Lecture notes, lectures 1-11
International Trade (RMIT)
ECON 1269 – INTERNATIONAL TRADE
Introduction – Why Study International Trade ?
Why should we study international trade ?
Because it is an area of obvious importance to every individual as well as the economy overall and society in general.
In what ways is it important ?
It influences the mix and the amount of goods and services that are available to society and so has an impact on our standard of living.
It influences the rate of economic growth of our country not least of all because many investment goods are imported from the rest of the world. This in turn influences productivity and so employment and wages.
It influences the distribution of income between countries and within the country.
Further, because of the importance and influence of international trade to the economy and the country it has become a central part of the policy debate and the policy making process.
Some of the trade issues that are regularly on the agenda are :
• The need for a level playing field
• Tariff reduction policy
• Agricultural subsidies
• The call for value added exports
• The Buy Australian campaign
• Membership of trade blocs
• Restructuring, industry policy, micro reform and privatisation
The context in which we will discuss this subject is not a new one.
We will focus on international trade theory as a debate between those who advocate free trade and those who advocate intervention in the trade process.
This debate has raged for centuries.
The 15th to 18th centuries were dominated by the Mercantilist view of the world.
Mercantilists argued against free trade and in favour of government control and intervention.
They saw exports as being good in that they added revenue or wealth to a country. Imports were seen as being bad in that they resulted in expenditure that decreased the wealth of a country.
This view was based on the need to maintain a large war chest to finance armies and navies which could protect the home country and its overseas colonies.
Wealth was generated by exporting more and importing less.
Self reliance was seen as being tremendously important as was the ability of domestic production to create jobs in the domestic economy .
Intervention was therefore seen as being desirable because it protected domestic markets and it promoted entry into foreign markets.
The Mercantilist view was a very nationalistic view and very anti free trade.
The 18th and 19th centuries were dominated by a more laissez-faire attitude.
Economists began to argue against the Mercantilist views and against government involvement.
Adam Smith in his 1776 Wealth of Nations suggested that free trade allowed specialisation in production and exchange that meant gains for all those who participated because of the improved efficiency generated.
He, and others, argued against trade restrictions because they simply promoted inefficiencies in resource allocation.
The new view of the world was that it was better to specialise in the production of what you were most efficient at, and then export the surplus to generate revenue to pay for imports of what you were less efficient at producing.
This would increase the wealth of your nation.
They argued against government intervention and in favour of free and unrestricted markets.
Post WW1 saw the rise of economic nationalism as the roaring 20s slipped into the Great Depression.
This was a period of time characterised by the rise of economic nationalism and the widespread implementation of beggar - thy - neighbour policies.
Post WW2 saw the rise of a range of international institutions that were essentially aimed at promoting free trade in the world economy.
Chief amongst these was the GATT which was very pro free trade.
Its stated position was to reduce and ultimately eliminate tariffs and to reduce a range of non - tariff barriers.
It was also anti customs unions.
GATT was far reaching in its views but was often referred to as a paper tiger.
It was replaced in 1997 by the WTO.
So there has been an on-going debate concerning the pros and cons of free trade versus intervention.
This debate has been alive for centuries and it continues today.
Our major concern in this course is to study the underlying reasons for and the implications of trade in goods and services.
Of course this also allows us to look at the reasons for and implications of intervention in the trade process as well.
The focus we will take in this discussion will be very much a theoretical microeconomic view of free trade and commercial policy.
This does not mean that other perspectives are not important but simply that first and foremost I will expect you to be able to analyse trade issues from an economists perspective.
Once the economics of the issue have been discussed you are free to amend your conclusion because of other concerns, but again, you must discuss the economics of the issue first.
And Now We Begin…
Our starting point in this subject is to ask a simple question. Why do countries trade ?
The simple answer must be that they benefit from the process, that is, they are better off after trade than they were before trade.
If this is the case then we can identify three major areas for discussion.
• What is the basis for trade between countries ?
• How does this determine the pattern of trade between countries ?
• How do country’s gain from trade ?
We can answer these questions by looking at the classical trade model as developed from the work of Adam Smith and David Ricardo and others.
The Law Of Absolute Advantage.
The first attempt to explain the basis of the trade process was Adam Smith’s Law of Absolute Advantage.
What is the law of absolute advantage ?
The law of absolute advantage states that a country that has an absolute advantage in the production of a commodity should specialise in the production of that commodity and then enter into exchange in the international marketplace and so make gains.
Absolute advantage is determined by the amount of input per unit of output or by productivity or by efficiency in production.
If you are absolutely more efficient or more productive than your trading partner in the production of a certain commodity then you should specialise and exchange accordingly.
Specialisation in production will lead to a more efficient allocation of resources.
Exchange will provide benefits to all those who participate because world output has been increased.
Lets look at a simple numerical example.
Assume a 2 x 2 model of the world economy and focus on productivity or output per manhour in both production processes in both countries.
Output per manhour Australia Taiwan
Wheat 6 1
Cloth 4 5
We can identify which country has the absolute advantage in which commodity by looking at absolute productivity levels.
Australia can produce 6 units of wheat per manhour while Taiwan can only produce 1 unit of wheat per manhour. Therefore Australia has an absolute advantage in the production of wheat.
Australia can only produce 4 units of cloth per manhour whereas Taiwan can produce 5 units of cloth per manhour. Therefore Taiwan has an absolute advantage in the production of cloth.
We can use this to explain how specialisation in production and international exchange will lead to gains from trade for all participating countries.
To do this we need to ask how far each country specialises and at what rate of exchange international trade will take place. For the sake of this example we will allow each country to specialise only to the extent that they devote one more hour to the production of their absolute advantage commodity and they will obtain this hour by devoting one less hour to the production of their absolute disadvantage commodity. We will also allow international exchange to take place at a rate of 1wh for 1cl in the international marketplace.
For each hour of specialisation in production according to its absolute advantage Australia gains 2c and Taiwan gains 4w.
Some Issues Not Yet Discussed.
• How far do we specialise ?
• Trade is not balanced.
• The gains are not equal between countries.
• The rate of exchange has not been explained.
These are all issues that we must address at some stage of our discussion.
The law of absolute advantage seems to provide a good starting point to our discussion of the basis for international trade.
It has one major problem however.
For it to provide a general explanation for observable international trade patterns there needs to be a reciprocal absolute advantage situation.
This means that each of our two countries must have the absolute advantage in the production of one commodity for absolute advantage to be able to explain two way trade.
This is typically not the case for the major part of modern international trade flows.
If we change our productivity matrix as indicated below.
Output per manhour Australia Taiwan
Wheat 6 1
Cloth 4 2
The law of absolute advantage cannot explain two way trade unless there is a situation of reciprocal absolute advantage.
The solution developed by David Ricardo and others was the law of comparative advantage.
The law of comparative advantage is a very important, widely applicable, and largely unchallenged law.
It provides the basis for a great proportion of observable international trade flows.
It holds even when there is no reciprocal absolute advantage.
This is the beginning of the Ricardian or Classical Model of international trade.
We will formally spell out the assumptions on which it is constructed later.
The law of comparative advantage says that even if one country has an absolute advantage in the production of both commodities it can still only have a comparative advantage in the production of one of them.
So each country must have a comparative advantage in one of the commodities.
The law states that each country should specialise in production according to its comparative advantage and then enter into international exchange and so make gains from the process.
A numerical example assuming no reciprocal absolute advantage.
Output per manhour Australia Taiwan
Wheat 6 1
Cloth 4 2
Explain why Australia despite having an absolute advantage in the production of both commodities still only has a comparative advantage in the production of wheat.
It follows that Taiwan despite having an absolute disadvantage in the production of both commodities must still have a comparative advantage in the production of cloth.
Assuming again a rate of exchange of 1w for 1c in the international marketplace we can demonstrate that if each country specialises in the production of the good in which it has a comparative advantage and enters into exchange in the international marketplace it will be better off.
This is particularly relevant from the Australian perspective because Australia should import cloth from Taiwan despite being absolutely more productive in the cloth industry that Taiwan.
Importantly, we now have a general explanation of the basis for trade that is widely applicable and can explain why trade should occur irrespective of productivity levels.
The only exception to the general applicability of the law of comparative advantage is the extremely unlikely situation where relative absolute advantages are equal.
In this case there is no comparative advantage to be exploited and so no gains from trade to be had for any country.
The Rate Of Exchange.
We can now focus briefly on the rate of exchange using the same productivity matrix.
We demonstrated that specialisation and international exchange generates gains to all participating countries.
To do this we assumed a rate of exchange of 1w for 1c.
Why did we choose this rate ?
The answer must be because it is acceptable to both countries.
We should therefore establish the boundaries to what will be acceptable to both countries and so what will encourage two way trade.
Australia would not accept less than 4c for 6w.
For Australia to agree to participate in international trade the rate of exchange needs to be consistent with 6w > 4c.
Taiwan would not accept less than 1w for 2c.
For Taiwan to agree to participate in international trade the rate of exchange needs to be consistent with 2c > 1w.
For two way trade to occur both of these constraints must be met simultaneously.
We need to scale and combine the two constraints to establish the acceptable boundaries for the common rate of exchange.
a 6w > 4c
b 2c > 1w
c multiply b by 6 12c > 6w
d combine a and c 12c > 6w > 4c
e divide d by 6 2c > 1w > 2/3c
Expressions e shows the boundaries that the rate of exchange must fall between if both countries are to agree to trade.
The rate of 1w = 1c fits the constraint.
Many other rates also fit within the boundaries, for example, 1w = 1 1/2c
Ratios that do not fit the constraints would mean that two way trade would not occur, for example, 1w = 4c
An Important Question.
Why would Australia import cloth from Taiwan if it can produce cloth more efficiently in the domestic economy ?
There can only be one answer.
The absolute price of Taiwanese cloth must be lower than the absolute price of Australian cloth.
To determine whether this is the case despite the productivity advantage we need to convert the productivity matrix into a price matrix.
To show that a comparative advantage in a productivity sense is consistent with an absolute advantage in a price sense we need to introduce two money variables.
These are the international wage differential and the international currency differential.
The introduction of wage rates allows us to convert output per manhour into price per unit. Remember that we are assuming a labour theory of value.
The introduction of the exchange rate allows us to express these prices in common currency terms.
Let us assume the following.
WA $A6 WT $T1 AND
Please note that the definition of the exchange rate assumed here is the following.
e number of $A
1 unit of $T
It follows from this that an increase in the exchange rate is a depreciation of the Australian currency.
In Australia one manhour costs $A6 and can be used to produce 6w or 4c.
This implies using the labour theory of value and assuming perfect competition that
In Taiwan one manhour costs $T1 and can be used to produce 1w or 2c.
This implies using the labour theory of value and assuming perfect competition that
We need to express these Taiwanese dollar prices in Australian dollar terms to make a valid common currency comparison of prices in the two countries.
For the given e=2 we simply multiply the Taiwanese prices to get the Australian dollar equivalent. This gives the following results.
P WT $T1 $A2
P CT $T0.50 $A1
The productivity matrix has in effect been converted into a price matrix.
Output per manhour Australia Taiwan
Wheat 6 1
Cloth 4 2
$A price per unit for e=2 Australia Taiwan
Wheat 1 2
Cloth 1.50 1
The underlying comparative advantage expressed in productivity terms shines through in an absolute price advantage.
The Possibility Of Monetary Distortions.
This pattern of absolute prices may not emerge if wage rates do not reflect productivity levels and / or the exchange rate is at the wrong level.
The monetary variables can distort the underlying productivity advantages and result in a pattern of absolute prices not consistent with two way trade.
If this is the case then we would expect to see the w and / or the e change until the underlying productivity did shine through in a pattern of absolute prices that was consistent with two way trade.
Of course, wage rates are typically less flexible than exchange rates and so the adjustment process is more commonly through exchange rate changes than through changes in the wage differential.
The boundaries within which the exchange rate must lie are :
3 > e > 1
The boundaries within which the wage differential must lie are :
2 WA e.WT 6
We need to be able to explain these boundaries and the adjustment process that leads to their establishment.
The Exchange Rate Distortion.
We can look at the exchange rate boundaries by focussing on exchange rates that provide prices that are not consistent with two way trade.
Our focus is on the e being too high or too low.
Let e=½, ie $A0.50 = $T1
$A price per unit for e=1/2 Australia Taiwan
Wheat 1 0.50
Cloth 1.50 0.25
In Australia we would see a higher Dfe to buy cheap imports and a lower Sfe as our exports decrease.
These both cause an increase in the trade deficit and so would be expected to lead to a depreciation of the exchange rate.
How far will the depreciation go, that is how far will the increase in the e go ? Until it is consistent with balanced two way trade.
Now let e=4,ie $A4 = $T1
$A price per unit for e=4 Australia Taiwan
Wheat 1 4
Cloth 1.50 2
This time we see Australia exporting both commodities and not importing either commodity from Taiwan. This results in a trade surplus that will generate an appreciation of the exchange rate, that is, a decrease in e given our definition of e.
How far will e fall ? Until it is consistent with balanced two way trade.
So if the e is too high or low we will have a distorted pattern of prices and so no two way trade. This imbalance in the trade outcome will lead to a change in the exchange rate that will continue until balanced two way trade is achieved based on the underlying productivity measurements.
The Exchange Rate Constraints.
What are the constraints on the exchange rate, what boundaries must it lie within ?
PWA e.PWT e PPWWTA
A e.PCT e PPCCTA
PPCCTA e PPWWTA
This must be true for each commodities domestic price.
In our case the numeric boundaries using each countries domestic prices are as shown below.
PCA 1.50 3
PWTA 11 1
The boundaries are therefore 3 > e > 1, and our chosen e=2 fits the boundaries.
The Wage Rate Constraint.
Now look at wage rates for a given e = 2.
Wage rates typically reflect productivity levels but in this analysis the wage differential must lie within identifiable boundaries.
This is so that the productivity benefit used to define the comparative advantage is not offset by wage costs being too high.
Remember that prices reflect productivity and factor prices.
Australia is 6 times more productive than Taiwan in its area of comparative advantage and 2 times as productive as Taiwan in its area of comparative disadvantage.
The Australian wage rate relative to the common currency exchange rate adjusted Taiwanese wage rate must be within the following boundaries.
WA < 6. e. WT
WA > 2. e. WT
WA > 2
WA = 6 = 3 the wage differential fits the constraints. and since
Typically wage differentials reflect productivity differentials, but if they do not then we would not have two way trade and so would expect to see pressure on the existing wage differentials to change.
Basically a high wage country makes for uncompetitive prices despite the underlying comparative advantage it may have in a productivity sense
The Ricardian Model.
The Ricardian Model that we are working with started with the development of the Law of Comparative Advantage. Our work using this Law has been based on several assumptions. Some of these have been explicitly spelt out whilst others have only been implicitly stated.
It is time we spelt the assumptions out in detail.
The Ricardian Model is in fact based on seven simplifying assumptions:
1 It is a 2x2x1 model.
2 Free trade between countries is assumed.
3 Labour is assumed to be freely mobile within but not between countries.
4 Constant costs of production are assumed to be exhibited in both industries in both countries. This implies that labour is perfectly substitutable between production processes.
5 There are no transport costs when trade between the two countries occurs.
6 There is no technical change for the duration of the analysis.
7 The labour theory of value is assumed to underpin costs of production and hence product prices.
Are these acceptable assumptions ?
The first six are simply simplifying assumptions that do not deter from the generality of the conclusions that are generated. The seventh assumption however is not a realistic or therefore acceptable in a modern economy and needs to be amended if our analysis is to be accepted.
The Labour Theory of Value implies that all units of labour are homogenous and that either labour is the only factor used in every production process or it is used in the same fixed proportion with other factors in every production process.
Neither of these assumptions is true or defensible. We therefore reject the Labour Theory of Value.
This does not mean we reject the law of comparative advantage, simply that we need to restate it. The restatement requires that we introduce the concept of opportunity cost into the analysis.
Opportunity Cost As A Basis For Determining Comparative Advantage.
Opportunity cost refers to the cost of what is given up to undertake any activity. We can change our production and price matrices to reflect the amount of output per production hour where a production hour incorporates all of the factors of production used in the production process.
We could set up a detailed input-output table and then by multiplying all factor quantities by all factor prices we would generate a price matrix that is based on the full or resource cost of the product and not just the embodied labour content of the product.
This could for example generate the following price matrix.
Cost/price per unit in $A Australia Taiwan
Wheat 1 2
Cloth 1.50 1
The matrix shows the full cost of all resources needed to produce one unit of each commodity in each country. Since costs and prices are interchangeable under conditions of perfect competition this is in effect a common currency price matrix reflecting the underlying productivity of all factors of production.
The opportunity cost in production is what you give up to produce one more unit of a commodity.
We can restate comparative advantage in terms of opportunity costs. The new rule to follow is that the country with the lowest relative opportunity cost is the country with the comparative advantage.
In Australia to produce one more unit of Wheat costs $1 and this means that $1 worth of resources needs to be taken out of Cloth production. The opportunity cost of producing an additional unit of Wheat is therefore the foregone production of 2/3 units of Cloth.
Using this approach we can set up an opportunity cost table as follows.
Australia +1Wh -2/3Cl
Taiwan +1Wh -2Cl
Australia +1Cl -1 1/2Wh
Taiwan +1Cl -1/2Wh
Comparative advantage can be determined by looking at the relative opportunity costs in production. The country with the low relative opportunity cost is the country with the comparative advantage in production because it has to give up less in terms of the foregone production of the comparative disadvantage good to free up the resources to produce more of the comparative advantage good.
In our example Australia has a comparative advantage in wheat production and Taiwan has a comparative advantage in cloth production.
So comparative advantage can be determined by opportunity cost. We can use it to demonstrate that specialisation in production and international exchange based on this comparative advantage will result in gains to each participating country.
A Short Cut Using Relative Price Ratios.
Note that the setting up of an opportunity cost table is relatively time consuming. A shorter way of arriving at the same result in terms of identifying which country has the comparative advantage is to simply look at the relative price ratios between the two countries involved.
For Australia Pw/Pc=2/3 and for Taiwan Pw/Pc=2.
Since Australia has the low price ratio it has the comparative advantage in the production of wheat. It follows logically that Taiwan has the comparative advantage in the production of cloth.
We will typically use this relative price ratio method as the main way of identifying a comparative advantage in the trade models that we develop.
Time To Introduce Some Diagrams.
We can now introduce the Production Possibilities Table (PPT) and use it to construct a Production Possibilities Curve (PPC) to illustrate the trade process and the generation of gains from trade for each participating country.
As an aside, note that the terms Production Possibility Curve (PPC) and Product Transformation Frontier (PTF) are used totally interchangeably in the textbooks and in this subject.
We are given the following information in terms of the productivity matrix and the price matrix.
Output per production hour Australia Taiwan
Wheat 6 1
Cloth 4 2
$A price per unit for e=2 Australia Taiwan
Wheat 1 2
Cloth 1.50 1
If we allow Australia a total of 30 (million) production hours and Taiwan a total of 60 (million) production hours and if we assume constant costs of production then we can generate the PPT’s and PPC’s for Australia and Taiwan.
The PPT shows the maximum output combinations of wheat and cloth for each country assuming full employment of all resources and an efficient allocation of all resources. They are generated for a given state of technology.
Wheat Cloth Wheat Cloth
180 0 60 0
150 20 50 20
120 40 40 40
90 60 30 60
60 80 20 80
30 100 10 100
0 120 0 120
These can then be used to plot the PPC’s for each country. The PPC shows the maximum output combinations of wheat and cloth that each country can produce assuming full employment of all resources, an efficient allocation of all resources and
a given state of technology.
0 30 60
0 20 40
90 120 150 180 210 240
The PPC shows what a country can produce. With the available resources and the available technology a country can produce anywhere on or inside the PPC. We assume full employment and an efficient allocation of resources and so each country will produce somewhere on the frontier and not inside the frontier.
• The PPC’s are linear which reflects the assumption of constant costs of production.
• Countries would like to produce outside the frontier but they do not have the resources or technology to do so.
• Since the PPC defines the production possibilities available to a country it also in effect defines the consumption possibilities available to consumers in that country. You can only consume what you produce in the face of no other sources of supply.
The Autarky Equilibriums.
Australia’s autarky equilibrium
Taiwan’s autarky equilibrium
The autarky or no trade production and consumption points are determined by society’s tastes and preferences. We can assume that producers and consumers interact in Australia with the result that 90 units of wheat and 60 units of cloth are produced and consumed. The same process in Taiwan results in 40 units of wheat and 40 units of cloth being produced and consumed.
We now allow specialisation in production and international exchange based on the identifiable comparative advantage in each country.
How do we identify the comparative advantage in each country ?
1 Relative opportunity costs (from the PPT’s). We see that 1wh has an opportunity cost of 2/3cl in Australia while 1wh has an opportunity cost of 2cl in Taiwan. Australia has the low opportunity cost in the production of wheat and so has the comparative advantage in the production of wheat. It follows logically that Taiwan has the comparative advantage in the production of cloth.
2 Relative price ratios (from the price matrix). We se (Pw/Pc)a=2/3 and (Pw/Pc)t=2. Thus Australia has the low price ratio and hence the comparative advantage in wheat. It again follows logically that Taiwan has the comparative advantage in cloth.
3 The absolute slope of the PPC can also be used to determine the comparative advantages. Note that the Australian PPC has a slope of 2/3 and the Taiwanese PPC has a slope of 2. Since Australia has the lowest slope value it has the comparative advantage in wheat. It follows logically again that Taiwan has the comparative advantage in cloth.
We give the slope of the PPC a special name. It is referred to as the Marginal Rate of Transformation of wheat for cloth. The MRT shows by definition the amount of cloth that needs to be sacrificed to free up sufficient resources to produce one more unit of wheat. It is the rate we can transform out of cloth production and into wheat production. It is another way of looking at opportunity cost and so another way of determining the comparative advantage that a country has. The country with the low MRT of wheat for cloth is the country with the comparative advantage in that commodity.
Here we see Australia with the low MRTwc and so Australia has the comparative advantage in wheat. It again follows logically that Taiwan has the comparative advantage in cloth.
Specialisation In Production.
Given that Australia has the comparative advantage in wheat and Taiwan the comparative advantage in cloth we would expect to see Australia specialise in wheat production and Taiwan specialise in cloth production.
How far will specialisation continue in each country ? Since for every additional unit of the comparative advantage commodity produced a gain will be made through international exchange each country will specialise completely in production. This means that each country will devote all of its resources solely to the production of the commodity in which it has a comparative advantage.
The result of this is shown in the table below where Australia produces 180 units of wheat and 0 units of cloth and Taiwan produces 120 units of cloth and 0 units of wheat.
Wheat Cloth Wheat Cloth
90 60 40 40
180 0 0 120
Exchange 110 70 70 50
Since consumers in each country will not be happy just consuming the one commodity that is being produced there must now be a process of international exchange. The point of specialisation in production is to allow each country to produce more of what it is relatively efficient at producing, thus generating an exportable surplus of this product that it can trade for imports of the commodity that it is relatively inefficient at producing.
For international trade to take place we must determine an acceptable ratio of exchange between wheat and cloth in the international marketplace. We can use a ratio of 1wh=1cl because it is acceptable to both countries
If we then assume that Australia and Taiwan negotiate a balanced trade outcome where Australia exports 70 units of wheat and in return imports 70 units of cloth, and of course where Taiwan exports 70 units of cloth and imports 70 units of wheat, we can determine the post international exchange consumption bundles for each country.
Note that if Australia trades 70wh for 70cl then it ends up with a consumption bundle of 110wh and 70cl and if Taiwan trades 70cl for 70wh it ends up with a consumption bundle of 70wh and 50cl.
0 30 60 90 120 150 180 210 240
The Taiwanese Free Trade Outcome
From the diagrams we can see that under conditions of autarky Australia produces and consumes at point A, after specialisation in production it produces at point b, and after international exchange it consumes at point C.
We can also see that under conditions of autarky Taiwan produces and consumes at point X, after specialisation in production it produces at point Y, and after international exchange it consumes at point Z.
The important point to note is that after specialisation and exchange based on comparative advantage both countries are consuming a bundle of wheat and cloth outside their PPC’s. That is , both countries are able to consume more that what they are able to produce.
We started by asking a simple question. Why do countries trade ? We suggested that they trade because they make gains from the process. We can now see that countries that do enter into international trade do indeed make gains from the process. We can see that both countries are able to consume outside their PPC’s, this means they have more real goods and services that what they are able to produce.
The explanation as to how this outcome arises is simple. By each country specialising according to its comparative advantage and producing more of what it is good at we see a more efficient allocation of the worlds resources and so an increase in the worlds output. This means that there is more available for the worlds consumers.
We have relied up to this point on a simple 2x2 model of the world. It is easy to extend our model to show that the conclusions generated can be extended to any number of commodities and any number of countries.
More Than Two Commodities.
If we allow five commodities and two countries we can still use our understanding of the law of comparative advantage to determine the pattern of trade.
If we are given the autarky domestic absolute prices for each commodity in each country, and if we remember that an absolute price advantage in common currency terms implies a comparative advantage in the production of that commodity, then we can determine who has the comparative advantage in each commodity.
We must again use an exchange rate to convert prices into common currency terms to enable us to make valid comparisons.
If we assume an exchange rate of 2 then we can determine the relative absolute prices for that given exchange rate and identify a chain of comparative advantage.
Commodity Australia Taiwan Taiwan
$A price $T price $A price for e=2
1 2 6 12
2 4 4 8
3 6 3 6
4 8 2 4
5 10 1 2
By converting the Taiwanese dollar prices for Taiwanese commodities into Australian dollar prices for a given exchange rate we can see that Australia has a comparative advantage in commodities 1 and 2, and that Taiwan has a comparative advantage in commodities 4 and 5. Neither country has a comparative advantage in commodity 3.
The pattern of trade can be determined from this chain of comparative advantage.
Note that if the exchange rate changes then the pattern of absolute prices will change and so may the pattern of trade change as a result. We would expect the exchange rate to continue to change until a pattern of trade consistent with the underlying comparative advantages expressed in productivity terms, and consistent with a balanced trade outcome, is achieved.
More Than Two Countries.
Now instead of two countries and five commodities we can look at a model with two commodities and five countries.
If we allow five countries to trade in two commodities and if we are given the autarky price ratio in each country then we can determine the pattern of trade. Since relative autarky price ratios can be used to determine comparative advantage we can rank the five countries according to their price ratios.
Up until this point we would simply now compare each country’s autarky price ratio to determine the comparative advantage in each commodity. This is no longer possible because it generates inconsistencies.
For example, country B’s autarky price ratio is less than country C’s autarky price ratio and greater than country A’s autarky price ratio. This suggests that country B has both a comparative advantage and a comparative disadvantage in commodity w. It suggests that country B should import and export the same commodity. This is obviously an absurd outcome.
When we have more than two countries we can no longer make direct country comparisons. We must in fact compare each country’s autarky price ratio separately with the world price ratio. Note that the five countries would all be participants in the world markets for wheat and cloth and so a world price for wheat and a world price for cloth would be generated that constitute the world price ratio.
If the equilibrium world price ratio is 3 then A and B will export wheat to D and E, C will not engage in trade at all, and. D and E will export cloth to A and B.
If the equilibrium world price ratio is 4 then A, B and C export wheat, D does not engage in international trade, and E exports cloth.
The equilibrium world price ratio will adjust to a level that is consistent with balanced trade between all of the participating countries.
Some people may ask why would country A import cloth from country C when it could import cloth from country B at a cheaper price. This in fact is not the case.
We should note that the world price ratio is just that, it is the ratio of the world price of wheat and the world price of cloth, where the world price for each commodity is determined in the world market for each commodity. Remember therefore that trade takes place between these five countries in these two commodities at common prices.
Finally, as in the two country case, there are boundaries within which the world price ratio must fall if any trade is to occur. The boundaries are the lowest and the highest of the various autarky price ratios.
We have looked at a simple model of international trade that can be used to illustrate how if countries specialise in production according to their comparative advantage, and then enter into international exchange, they will be better off.
While the model is a good starting point in looking at the intricacies of international trade it has three identifiable weaknesses that do not allow us to continue to develop our analysis.
These weaknesses are as follows.
1 An underdeveloped supply side story. Our assumption of constant costs of production results in complete specialisation in production and this is not realistic. We need to improve our supply side story. We will do this by introducing rising costs of production.
2 We have no demand side to this analysis and so we need to introduce a demand side if we are to fully understand the international trade process. We will do this by introducing social indifference curves into the analysis.
3 We have suggested that the world price ratio, or the terms of trade as it is often referred to, is very important in the analysis yet we have said nothing about what forces determine its value. We need to look more closely at the determination of the world price ratio and at its significance in this analysis.
This is in effect the end of the simple Ricardian Model and the beginning of the modern theory of international trade which we will ultimately call the HeckscherOhlin Model.
The Modern Theory Of International Trade
We have focussed on the important role of comparative advantage and used it to construct the simple Ricardian Model that shows all participating countries gain from participation in the free trade process.
The simple Ricardian Model has three weaknesses which we need to address.
The supply side assumes constant opportunity costs and so implies complete specialisation in production. This is not realistic so we will introduce rising opportunity costs to characterise the supply side more realistically.
There was no demand side to the model and so we will introduce the demand side by using social indifference curves.
With these two improvements we can reconstruct our analysis to show the gains generated to each participating country in a movement from no trade to free trade.
We can then address the third weakness. This is the lack of attention given to the explanation of the world price ratio.
Rising Opportunity Costs
We can start by constructing a PPT based on rising opportunity costs.
The PPT by definition shows the maximum output combinations of wheat and cloth that can be produced assuming full employment of all factors of production, an efficient allocation of all factors of production, and a given state of technology.
The assumption of rising opportunity costs in production means that to produce more of one commodity requires that ever increasing amounts of the other commodity must be given up. This is because resources :
• are not homogenous, and
• are not the only factor of production in every production process, and/or
• are not used in the same fixed proportion in every production process.
So, for example, a PPT for Australia, assuming rising opportunity costs in the production of wheat and cloth, may be illustrated by the table below.
Note carefully that each additional increment in wheat production requires more and more cloth production to be given up as the resources released from the cloth sector become less and less suitable for wheat production.
The same would be true if we were to substitute out of wheat production and into cloth production.
We can now plot the PPC
Production Possibility Curve Reflecting Rising Opportunity Costs in Production
Note that rising opportunity costs imply a PPC that is concave to the origin. The slope of the PPC is given by the MRT which is increasing, that is, more and more cloth must be given up to free up enough resources to produce each extra increment of wheat. This is seen clearly in the PPT.
Differences On The Supply Side Of Australia And Taiwan.
There is no reason to expect that Australia and Taiwan would have the same supplies of factors of production or the same technology. There is therefore no reason to believe that the Australian PPC and the Taiwanese PPC will be the same except in the characteristics associated with the common assumption of rising opportunity costs. This means that each country’s PPC will be concave and will exhibit a rising MRT but will be different in shape and position.
Their PPC’s will have the same characteristics but different shapes.
We will assume that Australia and Taiwan have :
• different factor endowments, and
• different technologies.
We will also assume that Australia has a greater ability to produce wheat because of its climate and land mass, and that Taiwan has a greater ability to produce cloth because of greater investment in its manufacturing sector.
Diagram 3.2A Diagram 3.2B
The Australian PPC The Taiwanese PPC
Efficiency In Production.
We also need to look at the efficiency condition for production.
The condition for efficient production requires that MRTwc=Pw/Pc in each country.
Why does this condition reflect an efficient production outcome ?
The efficient production paint is at point C where MRTWC = PW/PC.
Because there is an incentive to change production at any other production point that is not consistent with this condition. This is best illustrated by comparing the MRT and the Pw/Pc at production points that are not efficient.
At point A we see MRT<Pw/Pc. So the opportunity cost of producing more wheat is less than what wheat trades for in the market. Thus there is an incentive to produce more wheat or to move to the right around the PPC.
At point B we see MRT>Pw/Pc. So the opportunity cost of producing more wheat is greater than what wheat trades for in the market. Thus there is an incentive to produce less wheat or to move to the left around the PPC.
At point C we see MRT=Pw/Pc. So there is no incentive to increase or decrease wheat production. This is the efficient production point.
The Demand Side.
We can now introduce a demand side to our analysis. This can be achieved by using social indifference curve analysis
Social indifference curves or country indifference curves or community indifference curves are very similar to individual indifference curves.
We can start by refreshing our memories concerning individuals indifference curves and then we can relate the individual indifference curve map to an individuals demand curve for a product. This is necessary because we will use the community indifference curve map to represent the demand side in our model.
An Individuals Indifference Curve Map.
An individuals indifference curve map is based on the simple notion that the individual can compare different bundles of wheat and cloth and can rank them according to the level of satisfaction they would generate.
Bundles which provide the same degree of satisfaction, that is, bundles between which the individual is indifferent, appear on an indifference curve.
Bundles which provide greater satisfaction appear on a higher indifference curve.
Bundles which provide less satisfaction appear on a lower indifference curve.
Every possible bundle of wheat and cloth can then be expected to appear uniquely on a single indifference curve. By definition an indifference curve shows all of the bundles of wheat and cloth that provide the same level of satisfaction to a consumer.
We could draw an indifference curve map for the individual.
An individuals indifference curve map from which a demand curve can be generated.
Note that the level of satisfaction achieved increases as the in dividual has access to bundles on higher indifference curves. We assume that the objective of consumers is to maximise satisfaction, that is, to achieve the highest attainable indifference curve in their consumption decisions.
We should also note that indifference curves are ordinal and not cardinal. That is, a higher indifference curve represents higher satisfaction but the increase in satisfaction is not quantifiable.
There are some important characteristics that a standard indifference curve map will exhibit and which we must be careful to adhere too.
• Indifference curves must be negatively sloped because more is preferred to less.
It is conceivable that bundles in the NW quadrant could appear on the same indifference curve as bundle A.
It is conceivable that bundles in the SE quadrant could appear on the same indifference curve as bundle A.
It is not conceivable that bundles in the NE quadrant or in the SW quadrant could appear on the same indifference curve as bundle A.
So the only conceivable indifference curve could join bundles A, B and C but not D or E and must therefore have a negative slope.
Indifference curves must have a negative slope.
• Indifference curves cannot intersect because of law of transitivity.
The Law of Transitivity implies that indifference curves cannot intersect
If the individual consumer is indifferent between bundles A and B, and indifferent between bundles A and C, then the law of transitivity implies that he/she must be indifferent between bundles B and C as well. This is obviously not the case in the diagram as bundle C has more of each commodity than bundle B and would therefore provide more satisfaction and appear on a higher indifference curve.
These inconsistent outcomes are avoided if we remember that logically indifference curves cannot intersect.
• Indifference curves are convex to the origin. This means that they not only have a negative slope but the slope is diminishing.
The slope of an indifference curve is called the Marginal Rate of Substitution. It is the rate a consumer substitutes out of cloth and into wheat while maintaining the same level of satisfaction. Technically it tells us the amount of cloth the consumer is willing to sacrifice to obtain one more unit of wheat while staying on the same indifference curve. The amount of cloth the consumer is willing to sacrifice to obtain ever increasing quantities of wheat decreases as we move around an indifference curve.
The MRS is assumed to be diminishing because of satiation in consumption. Basically this means that as a consumer obtains more and more of one commodity they value it less and less in terms of the other commodity.
Indifference curves are convex to the origin because of satiation in consumption. The more an individual has the less he/she values it in terms of the other commodity.
Efficiency In Consumption.
We can use the indifference curve map to explain what we mean by efficiency in consumption.
The efficiency condition requires that the MRS=Pw/Pc.
Remember that the MRS is the slope of the indifference curve and the Pw/Pc can be shown to be the slope of the consumers budget constraint. This implies that the efficient consumption point will occur at a point of tangency between the highest attainable indifference curve and the budget constraint. The efficient consumption bundle is that bundle that maximises consumer satisfaction.
We can illustrate this outcome by assuming, for example, that an individual consumer has a given total level of expenditure and faces given prices for wheat and cloth. Let TE = $200, Pw = $10, and Pc = $5.
The budget constraint drawn for a given TE, PW and PC. It shows the
consumption possibility available to the individual given the expenditure
and price constraints shown.
If total available expenditure was used to only purchase cloth at $5 per unit a maximum of 40 units of cloth could be purchased. If total available expenditure was used to only purchase wheat at $10 per unit a maximum of 20 units of wheat could be purchased. Since prices are constant per unit we can join these two intercepts to define the consumption choices available to the consumer.
This line is referred to as the budget constraint. It shows the consumption choices available to the consumer for a given level of expenditure and given prices.
Note that the slope of the budget constraint is given by Pw/Pc.
Which of the available bundles will the consumer choose to consume ?
We assume that the consumer attempts to maximise satisfaction with his/her consumption decisions and so will choose to consume that bundle of wheat and cloth that appears on the highest attainable indifference curve.
This must be at a point of tangency between the budget constraint and the indifference curve. Such an outcome is characterised by the condition that the MRS=Pw/Pc. This is seen at point A in the diagram.
The efficient consumption point A where MRS = PW/PC and satisfaction is maximised subject to the constraints.
Note that we can see the consumption bundle of wheat and cloth that will be chosen by this individual if the desire is to maximise satisfaction. For the given level of expenditure and the given product prices the efficient consumption bundle is W0 and C0.
There are many other possible consumption bundles available to the consumer but they all provide a lower level of satisfaction.
In the diagram points B and C represent bundles of wheat and cloth that are available to the consumer as they lie on the budget constraint. So why should the consumer choose bundle A instead of bundle B or bundle C ?
At bundle B we see MRS >Pw/Pc. This means that the amount of cloth that would be given up to obtain one more unit of wheat while staying on the same indifference curve is greater than the amount that needs to be given up in the market to obtain one more unit of wheat. So by increasing wheat consumption a greater level of satisfaction can be achieved.
The opposite is true at point C.
Points B and C are net efficient outcomes as MRS PW/PC. An adjustment in consumption would lead to greater satisfaction being achieved.
The only time that satisfaction cannot be increased is at point A where we have a tangency between the highest attainable indifference curve and the budget constraint.
The Individual Demand Curve For Wheat.
We can derive the individual demand curve for wheat from the indifference curve – budget constraint diagram.
A demand curve shows the quantity of a commodity an individual is willing and able to purchase at each possible price level. We can see that our individual is willing and able to purchase W0 units of wheat at a price of $10 per unit. This gives us one point on a demand curve for wheat.
If we now decrease the price of wheat to $5 per unit we should be able to determine what happens to the consumption of wheat and so generate another point on the demand curve.
The lower price of wheat will mean that the budget constraint rotates and a new consumption possibility set is defined. Our consumer will respond to the new price and new consumption choices by changing his/her consumption bundle to maximise satisfaction under the new constraints. Point D is the new efficient consumption point because it is where the highest attainable indifference curve is achieved and where MRS=Pw/Pc. It also shows that at Pw=$5 consumption of wheat is at W1. We now have a second point on the demand curve.
The demand curve for wheat can be generated by deriving a series of points showing consumption / demand for different prices and then joining those points to form a curve.
As the PW decreases the budget constraint rotates to reflect the new
consumption choices. Our consumer will move to the new efficient
consumption point at D.
The Demand Curve for Wheat.
From The Individual To The Community…
We can relate the individuals indifference curve map to society’s indifference curve map.
A social indifference curve shows the various combinations of wheat and cloth that provide the same total satisfaction to a country.
It has all the properties of the individuals indifference curve map except for one major difference.
When an individual moves on to a higher indifference curve it is unambiguously the case that the individual is better off. However, when a country moves on to a higher social indifference curve while it is unambiguously the case that the country is better off it does not mean that everyone in the country is necessarily better off.-
Think of this in the context of international trade providing gains to all participating countries. While the country is better off there are clearly going to be gainers and losers within the country itself. As we specialise in production our exporters benefit but our domestic producers of import substitutes lose. Consumers may be better off or worse off depending on their consumption patterns.
To overcome this problem we rely on the compensation principle. This is based on the notion that because the country as a whole is better off the gainers could compensate the losers and still be better off themselves. This means there could potentially be no losers and at least some winners
This does not mean that compensation actually takes place and so our use of the social indifference curve approach is not entirely satisfactory. We will need to return to the question of internal income distribution issues at a later point to deal with this concern.
From this point on we will be using a social indifference curve map to represent the demand side of the economy in our analysis.
The Modern Theory Of International Trade.
Now lets reconstruct our model of free trade using the new material.
Supply conditions assume rising opportunity costs and so concave PPC’s. Importantly this implies a rising MRT as seen by the slope of the PPC.
By assuming different factor supplies and different technology between the two countries we generate PPC’s that have the same characteristics but different shapes.
The Australian PPC The Taiwanese PPC
Demand conditions are summarised using social indifference curves which have all the properties of individual indifference curves. Importantly the slope of the indifference curve is the MRS which is diminishing.
By assuming different tastes and preferences between the two countries we generate indifference curve maps that have the same characteristics but different shapes.
There is no reason to believe that tastes and preferences between countries should be the same. For the sake of our analysis we will assume Australians prefer cloth to wheat and Taiwanese prefer wheat to cloth.
This implies indifference curve maps with the same characteristics but different shapes as shown in the diagram.
Australian Indifference Curve Map Showing
A Preference for Cloth
Taiwanese Indifference Curve Map Showing
A Preference for Wheat
Autarky Price Ratios.
The differences in demand and supply conditions between countries imply differences in both absolute and relative prices under conditions of no trade..
We would expect to see
• PwA as relatively low because of large supply and low demand
• PcA as relatively high because of small supply and high demand
• PwT as relatively high because of small supply and high demand
• PcT as relatively low because of large supply and low demand
These absolute prices imply the following pattern of relative price ratios, (Pw/Pc)A <
This in turn implies that Australia has a comparative advantage in wheat production and Taiwan a comparative advantage in cloth production.
In our analysis we will assume that the differences on the supply sides and the differences on the demand sides lead to autarky price ratios of ¼ in Australia and 4 in Taiwan.
We will show that through specialisation and trade a common world price ratio or terms of trade will be generated that is consistent with both countries gaining from the trade process.
We will assume a world price ratio of 1. This will need further explanation later in the subject.
We can now use this information to build and explain the diagrams that show how a movement from autarky to free trade generates identifiable gains to each participating country.
The Australian Autarky Equilibrium
We will focus on Australia to begin with and look at the movement from no trade to free trade.
If we draw the PPC and look for the highest attainable social indifference curve we will be able to identify the tangency outcome that is consistent with efficiency in production and efficiency in consumption. We should note that the efficient production point and the efficient consumption point must coincide under conditions of autarky as consumers must consume what is produced as they have no other choice.
This tangency implies a price ratio that is consistent with both product markets being cleared and forms part of the efficiency outcomes. This price ratio is in effect determined by the interaction of buyers and sellers in the domestic wheat market and the domestic cloth market.
Efficiency in production requires MRT=Pw/Pc and this occurs at point A.
Efficiency in consumption requires MRS=Pw/Pc and this occurs at point A
We have given the autarky price ratio a value of ¼..
Now Allow Trade…
Now we allow Australia to enter into international trade.
The important thing to note is that trade will generate a new world price ratio that is different than the autarky price ratio. We would therefore expect producers and consumers to change their behaviour as they respond to the new price ratio and seek new efficient outcomes.
We will without explanation at this stage, allow (Pw/Pc)*=1. This lies between (Pw/Pc)A=1/4 and (Pw/Pc)T=4.
Remember that these are all arbitrary but illustrative figures, all we really know from our assumptions about domestic demand and supply conditions in Australia and Taiwan is that (Pw/Pc)A<(Pw/Pc)T.
We can ask :
• What will the production response be?
• What will the consumption response be?
The Production Response.
The production response sees Australian producers following their comparative advantage in the production of wheat and increasing wheat production from W0 to W1. To obtain the resources to increase wheat production cloth production decreased from C0 to C1. The production response is therefore represented by the move from move from producing at point A to producing at point B.
Why does the production response take Australian producers to point B where specialisation is not complete ?
The answer is because the new efficient production point is where MRT=(Pw/Pc)*, and this is at point B.
The Australian Production response
Why is this the efficient production point ?
By looking at the diagram we can see the MRT at point A is ¼. This means that 5 units of cloth needed to be given up to free up the resources to produce 20 units of wheat. These 20 units of wheat were worth 5 units of cloth in the marketplace at the autarky price ratio of ¼.
With the new world price ratio of 1 we now see 20 units of wheat being worth 20
units of cloth in the world markets. Thus there is an incentive now to further increase wheat production beyond point A because the return is now greater than the cost.
Remembering that we have a world of rising opportunity costs the next 20 units of wheat produced may cost the foregone production of 7 units of cloth but they are worth 20 units of cloth in the world markets.
The incentive to further increase wheat production remains.
The next 20 units of wheat may cost 11 units of cloth…, and the next 20 units of wheat may cost 15 units of cloth…, and the next 20 units of wheat may cost 20 units of cloth…
The process of specialisation will only stop when there is no longer an incentive to produce more wheat. This occurs at point B where 20 units of cloth are given up to produce 20 units of wheat and the return for 20 units of wheat is 20 units of cloth. To specialise further would involve, for example, giving up 25 units of cloth to get 20 units of wheat and those 20 units of wheat only being worth 20 units of cloth.
It is profitable to move from A towards B but not beyond B.
Point B is the efficient production point because it is where MRT=(Pw/Pc)*.
Note again that specialisation is not complete in that Australia at point B is producing more wheat than under autarky but it is also still producing some c1oth. This is the more realistic outcome generated from a model that assumes rising opportunity costs in production.
The Consumption Response.
While Australia is producing at point B, consumers in Australia will not be happy consuming at that point.
If we look at the shape of the Australian indifference curve map point B must be on a
lower indifference curve. than point A
So Australian consumers will want to trade away from point B because with the possibility of international exchange we are no longer forced to consume exactly what we produce.
In what direction will they trade?
Rational consumers always substitute in consumption towards the relatively cheaper good.
Since our model is constructed assuming rising opportunity costs then as we specialise according to our comparative advantage and produce more wheat and less cloth we would expect to see the price of wheat in Australia increase and the price of cloth in Australia decrease.
This is also consistent with the price pressures generated from the demand side in the face of new consumption opportunities becoming available through international trade.
So consumers in Australia will trade away from point B by consuming more of the now cheaper cloth and less of the now more expensive wheat.
At what rate can they trade out of wheat and in to cloth ?
The world price ratio of (Pw/Pc)*=1 tells us that 1unit of wheat trades for 1 unit of cloth in the international marketplace.
So Australia can trade away from B at a rate of 1 cloth for 1 wheat. This defines the new consumption set as being consistent with the (Pw/Pc)* line.
The post trade consumption point C lies on the world price ratio line and is consistent with the highest attainable social indifference curve.
Where along this new consumption line will Australia choose to consume?
The most efficient consumption point is obviously at the point of tangency between the highest attainable indifference curve and the price line.
The highest attainable indifference curve is obviously higher than the indifference curve attainable under no trade.
The free trade outcome is efficient in production and efficient in consumption.
However consumers are no longer constrained to consume what they produce.
MRS=(Pw/Pc)* and MRT=(Pw/Pc)* but the production and consumption points no longer need to coincide.
Our original question was why do countries trade ?
The answer must be because countries can operate on higher and previously unattainable indifference curves. They have access to more real goods and services. They can in fact consume outside their PPC’s.
The gains that are identifiable by the movement from i0 to i2 are underpinned by the relaxation of the constraint on consumers and the opportunities provided to producers.
The Taiwanese Perspective.
Now repeat the exercise from the Taiwanese perspective.
The Taiwanese production response sees a movement from X to Y and the consumption response sees a movement from Y to Z.
The World Perspective.
The no trade equilibrium in Australia has MRS = MRT = (Pw/Pc)A = 1/4.
The production response in Australia has MRT=(Pw/Pc)*=1.
The consumption response in Australia has MRS=(Pw/Pc)*=1.
The no trade equilibrium in Taiwan has MRS = MRT = (Pw/Pc)T = 4.
The production response in Taiwan has MRT=(Pw/Pc)*=1.
The consumption response in Taiwan has MRS=(Pw/Pc)*=1.
Since the world price ratio is common for both countries then we have the most efficient outcome for the world as a whole after trade but not before trade.
Free trade not only increases welfare in each country it in fact maximises world welfare.
Some Extensions Of The Model.
So far we have looked at :
-the efficiency conditions
-the autarky equilibriums
-the production response
-the consumption response
-the free trade equilibrium
-the other country
The conclusions that we arrived at were that both countries were made better off through trade and international exchange, and that further than that free trade in fact maximises world welfare.
Now we can focus on the diagrams that we have constructed to draw out some of their implications. Our primary goal inn this lecture is to be able to comment on the forces that determine the distribution of the gains from trade between our two countries.
The Trade Triangles.
We can start by identifying the trade triangles and then we can use these triangles to comment on various implications of the model we have constructed.
Diagram 4.1The Australian Trade Triangle isn CDB, with base of W 1 – W2 or expAW, height of C2 – C1 or impCA, and hypotenuse of (Pw/PC)* = 1.
Diagram 4.2The Taiwanese Trade Triangle is YWZ, with base of W 2 – W1 or impTW , height of C1 – C2 or expCT, and hypotenuse of (Pw/PC)* = 1.
The trade triangle for each country can be mapped out by showing the that the quantities of imports and exports for each country form the base and the height of a right angle triangle which has an hypotenuse given by the world price ratio.
Once we have identified the trade triangles we can interpret them in a range of ways.
We could show that the value of Australia’s exports equals the value of Australia’s imports, and that the value of Taiwan’s exports equals the value of Taiwan’s imports.
This is most easily done by recognising that the slope of the hypotenuse of each triangle is equal to the height of the triangle divided by the base of the triangle.
For Australia we see that :
ImpcA/ExpwA = Pw*/Pc*
and therefore that :
(Pw* x ExpwA) = (Pc* x ImpcA).
This means that the value of exports from Australia is equal to the value of imports into Australia.
For Taiwan we see that :
ExpcT/ImpwT = Pw*/Pc*
and therefore that :
(Pw* x ImpwT) = (Pc* x ExpcT).
This means that the value of imports into Taiwan is equal to the value of exports from Taiwan.
So we can conclude that trade within each country is balanced.
We can also suggest that trade between countries is balanced because in physical terms ExpwA = ImpwT and ExpcT = ImpcA , which together with a common Pw* and Pc* tell us that Australia’s export receipts are equal to Taiwan’s export receipts and that Australia’s import expenditures are equal to Taiwan import expenditures.
Since trade in value terms is balanced between countries there is no exploitation taking place.
The trade triangles can be used to give us an insight into the basis of the gains from trade.
What the triangles show is that instead of consumers consuming physically what is produced they are constrained to consume a value of goods and services equal to the value of the goods and services produced.
This is a far less severe restriction.
It is shown by the fact that the value of each country’s imports equals the value of its exports. Thus the value of production must equal the value of consumption.
We have assumed a world price ratio or terms of trade of 1 in our examples so far.
It is worth repeating that the figure of 1 is chosen because it is easy to manipulate and because it fits within the established constraints given by the autarky price ratios of 1/4 and 4.
There is nothing magical or necessary about the figure 1 in the international trade context.
One thing it does imply however is that the physical quantity of exports and the physical quantity of imports are not only equal between the countries (as they must be) but also equal within the countries.
So if Australia is for example exporting 270 units of wheat then it will be importing 270 units of cloth in return.
Why must this be the case ?
If the trade triangles show (Pw* x ExpwA) = (Pc* x ExpcT ) and if Pw* = Pc*, which it does if (Pw/Pc)* = 1, then it follows that ExpwA = ExpcT.
If the terms of trade took on a value between ¼ and 4 but was not equal to 1 then all of our conclusions would still follow except there is no need for physical quantities exchanged to be equal.
The value of exports and the value of imports still need to be equal but the physical quantities would be different. For example, if (Pw/Pc)* = 3 then 1Wh = 3Cl. So, if Australia exported 30Wh it would receive imports of 90Cl in return.
If (Pw/Pc)* = 3 then it also follows that for example if Pw* = $15, then Pc* = $5.
Since (Pw* x ExpwA) = ($15 x 30units) = $450, and since (Pc* x ExpcA ) = ($5 x 90units) = $450, then it is clear that trade is balanced in value terms despite physical quantities not being equal.
If we assume (Pw/Pc)* = 1 is the equilibrium world price ratio then any other price ratio that fits within the boundaries of ¼ and 4 could not persist over time.
Any other price ratio would allow two way trade but trade could not be balanced and so an adjustment process would be triggered.
For example, assume the equilibrium (Pw/Pc)* = 1 but the actual (Pw/Pc)* = 2.
We can show that Australia would want to specialise further and export more and that Taiwan would want to specialise less and import less at this price ratio than at the equilibrium price ratio.
The results would be :
• an ESw in the world wheat market and so downward pressure on Pw* which in turn puts downward pressure on (Pw/Pc)*, and
• an EDc in the world cloth market and so upward pressure on Pc* which in turn also puts downward pressure on (Pw/Pc)*.
These pressures would continue until (Pw/Pc)* returned to its predetermined equilibrium value of 1.
Of course, if the actual (Pw/Pc)* = ½ then the resulting adjustment process would cause the (Pw/Pc)* to increase towards its equilibrium value of 1.
The major point is that if disequilibrium occurs then an automatic adjustment process is triggered that pushes us towards the balanced two way trade equilibrium.
The Distribution Of The Gains From Trade.
We have seen that as long as pretrade or autarky price ratios are not equal between countries there is a basis for mutually beneficial two way trade.
The end result of the trade process is balanced trade between Australia and Taiwan.
We know that both countries gain from the trade process but we know nothing about the distribution of the gains from trade between the countries. Do they gain equally ? If they do not gain equally then which country gets what share of the gains ? These are issues that are important and so we can now turn our attention to what determines the distribution of the gains from trade between countries.
The Starting Point…
The starting point is to note that specialisation and exchange eliminate the pretrade differences in price ratios that underpinned the trade process. Trade leads to the establishment of a common world price ratio that can be expected to lie between the two no-trade price ratios.
Why is this the case ? Because with specialisation and trade we would expect to see the following:
An EDwA leading to upward pressure on PwA.
An EScA leading to downward pressure on PcA.
An ESwT leading to downward pressure on PwT.
An EDcT leading to upward pressure on PcT.
These translate into upward pressure on the price ratio faced in Australia and downward pressure on the price ratio faced in Taiwan.
Since the Australian autarky price ratio was originally less than the Taiwanese autarky price ratio, the movement in the price ratios generated by the trade process must inevitably push each country’s price ratio closer together.
Where does this process end ?
As long as there is a difference in price ratios there is a comparative advantage that can be identified and exploited. This means that there are more gains from trade available to those who continue to specialise in production and enter into international exchange. The process will therefore continue until all the available gains from trade have been exploited.
This means that the end result of the trade process must be the establishment of a common world price ratio that lies between the two autarky price ratios.
The Importance Of The Common World Price Ratio…
We can suggest that it is the position of the world price ratio relative to the autarky domestic price ratios that in fact determines the distribution of the gains from trade.
As a general rule, the closer the world price ratio is to a country’s autarky price ratio the smaller will be that country’s share of the gains from trade.
But recognise that this must mean that the world price ratio is further away from the other country’s autarky price ratio and so the greater will be that country’s share of the gains from trade.
It is in effect a zero sum game in the sense that one country can only increase its share of the gains from trade if the other country’s share decreases.
A Numerical Example.
The easiest way to illustrate this proposition is to use a simple numerical example.
Pw/Pc W C Pc/Pw C W
1/8 1 1/8 8 1 8
Aust autarky 1/4 1 1/4 4 1 4
1/2 1 1/2 2 1 2
1 1 1 1 1 1
2 1 2 1/2 1 1/2
Taiw autarky 4 1 4 1/4 1 1/4
8 1 8 1/8 1 1/8
The table shows a range of potential world price ratios that can be compared to the Australian and the Taiwanese autarky price ratios to illustrate the outcomes in terms of the distribution of the gains from trade.
Note that the table shows Pw/Pc and what that means in terms of the quantity of cloth one unit of wheat would exchange for, and then it shows the equivalent Pc/Pw and the quantity of wheat one unit of cloth would exchange for. This allows us to see the distribution question from the point of view of Australia trading wheat and from the point of view of Taiwan trading cloth.
Start by looking at a world price ratio of 1. By comparing this to each country’s autarky price ratio we can see that both countries gain from international trade.
If we then look at a world price ratio of ½ we can again see that both countries gain but that the Australian share of the gains has decreased while the Taiwanese share of the gains has increased. The closer the world price ratio is to the autarky price ratio the smaller is that country’s share of the gains from trade but the larger must the other country’s share be because the world price ratio must be further away from its autarky price ratio.
If we then look at a world price ratio of ¼ we see that Australia would not gain from trade at all but that Taiwan would gain huge amounts. Since one of the countries does not stand to gain from trade there will be no trade. The autarky price ratio in Australia is therefore one of the boundaries above which the world price ratio must lie.
This outcome is reinforced if we look at a world price ratio of 1/8. We can see that Australia would in fact lose if it traded at this price ratio and so there will be no international trade as the world price ratio lies outside the acceptable boundary from the Australian perspective.
The process can then be repeated for a world price ratio of 2, 4 and 8. We see the Australian share increasing at the expense of the Taiwanese share at 2. We see Taiwan not gaining at all at 4 and so the establishment of the upper boundary to the world price ratio at the Taiwanese autarky price ratio. We see Taiwan in fact losing from trade if the world price ratio is 8, or in fact any value greater than 4.
If the world price ratio was :
• 1 both countries gain.
• ½ both gain but Taiwan’s share has increased.
• ¼ Australia makes no gains so a boundary is established.
• 1/8 Australia would lose so no trade takes place.
• 2 both gain but Australia’s share has increased.
• 4 Taiwan makes no gains so a boundary is established.
• 8 Taiwan would lose so no trade takes place.
The general statement is that both countries gain from trade but not necessarily equally. It is the position of the world price ratio relative to the autarky price ratios that determines the distribution of the gains from trade. The further away the world price ratio is from the autarky price ratio the greater is that country’s share of the gains from trade but the smaller must the other country’s share become.
While we know that the world price ratio must be somewhere between the autarky price ratios we cannot say where it will end up. It really depends on each country’s flexibility in terms of resource allocation and production techniques.
We should also stress that we have as yet said nothing about the internal income distribution consequences of the trade process.
The Source Of The Gains From Trade.
We can demonstrate that the trade process generates gains to all participating countries, and we can demonstrate the importance of the world price ratio in determining the distribution of the gains from trade between countries, but we have not looked very closely at the source of the gains from trade.
We can in fact identify a gain attached to specialisation in production and a gain attached to exchange in the international marketplace.
The decomposition of the total gain from trade into a production gain and an exchange gain can be illustrated by restricting producers in a country from responding to the new world price ratio but allowing consumers to respond to the new opportunities.
The restriction on the production response may be because of existing production contracts and/or particular resource constraints.
Using the familiar diagrams we can restrict Australian producers from specialising in production but allow Australian consumers to trade at the new world price ratio.
Total gains from trade in Australia are represented by the movement from iThese can be decomposed into the pure exchange gain i0 to i1, and the production 0 to i2. gain i1 to i2.
The movement from i0 to i1 represents a pure exchange gain.
The movement from i1 to i2 represents a gain due to specialisation in production.
The total gain from trade is represented by the movement from i0 to i2.
This is best seen by determining the point from which consumers are trading away from and the rate at which international exchange can take place.
The situation for Taiwan can also be demonstrated in the same manner.
The total gains from trade in Taiwan are represented by the movement from C0 to
Where Does The Comparative Advantage Come From ?
The basis for trade has been shown to be a difference in the autarky price ratios. We have suggested that the difference is due to differences on the supply side and on the demand side of the Australian and Taiwanese economies.
We can demonstrate that even if the two country’s have identical PTF’s there will still be a basis for trade as long as tastes and preferences are different between the two countries.
Let us assume that we have identical supply sides but that Australians prefer cloth to wheat and that Taiwanese prefer wheat to cloth.
This implies that (Pw/Pc)A < (Pw/Pc)T because we would expect that PwA be less than PwT and that PcA be greater than PcT.
This is because the country with the higher preference for a good would be expected to have the higher price for that good and so will have a comparative disadvantage in its production.
Since we can identify the comparative advantages from the autarky price ratios we can tell our familiar trade story.
We can start by illustrating the autarky price equilibriums and identifying the implied autarky price ratios from which the comparative advantages can be determined.
The autarky equilibrium in Australia (point A) and Taiwan (point X) with identical supply sides.
If we now allow trade to take place then a world price ratio of 1 could be established. Each country then specialises in production and enters into international exchange and makes gains from trade as a result.
The free trade equilibrium in Australia (points B and C) and Taiwan (points Y and Z).
So we have mutually beneficial trade based solely on differences in tastes and preferences between countries. Later in the H-O model we can look at the exact opposite case where trade is based exclusively on differences in factor endowments.
The Determination Of The Terms Of Trade.
We have developed a model that has looked at the basis for and the gains from trade. In this model the world price ratio or terms of trade has played an extremely important role in determining the outcomes we have seen.
We now need to look in more detail at how the TOT is actually determined. In the process we can highlight the forces that can cause the TOT to change.
There are two approaches that we will look at.
• The first is the general equilibrium approach in which is an aggregate approach. This allows us to introduce offer curves into our analysis.
• The second is the partial equilibrium approach which is a disaggregate approach. Here we will revert back into the more familiar demand and supply analysis.
Our focus will be on the offer curve approach because we have taken a general equilibrium approach to trade theory so far in this subject. However the partial equilibrium method is also important because of three important considerations.
• It allows us to look at marginal efficiency conditions.
• It allows us to focus on the welfare implications of the trade process.
• It is the context in which we will analyse intervention in the trade process later in the subject.
By definition an offer curve shows for each world price ratio the amount of exports a country is willing to offer and the amount of imports it expects to receive in return.
The Australian Offer Curve.
We can look at the derivation of the Australian Offer Curve by referring to the trade triangles that would exist at a range of world price ratios as they tell us the amount of exports and imports Australia is willing to trade at that price ratio.
If we start at a world price ratio equal to the autarky price ratio we see that Australia is not willing to enter in to international trade. This suggests that the Australian Offer Curve passes through the origin at the autarky price ratio.
If we now allow new price ratio we can map out production and consumption responses and identify the resulting trade triangle. This tells us the amount of wheat Australia is willing to export and the amount of cloth it expects to receive in return at that world price ratio. This provides another point on the Australian Offer Curve at that price ratio.
If we then move the world price ratio further away from the autarky price ratio we generate a further point on the Australian Offer Curve. Note that we would expect the trade triangle to be larger at this price ratio.
By repeating the process several times we generate enough points to plot the Offer Curve.
Diagrams 5.1A, 5.1B and 5.1C. At different world prices ratios we can see the amount of trade Australia is willing to enter into.
By plotting the information contained in the above diagrams we can generate the Australian Offer Curve.
Some Notes On The Offer Curve.
• By definition it shows for each Pw/Pc how much wheat Australia is willing to export and how much of cloth it expects to import in return from Taiwan
• To interpret the Offer Curve simply look for the intersection of any possible world price ratio with the Offer Curve and from there you can determine the quantity of wheat Australia is willing to export and the quantity of cloth it expects to be offered in return.
• The Offer Curve bows towards the country’s export axis.
• It is an equilibrium line in that it captures all demand and all supply conditions, it summarises efficient consumption and production points, and each point on it is consistent with trade being balanced because it essentially summarises the various trade triangles.
• In a welfare sense as we move out along the offer curve we are better off as a country because we are operating on a higher social indifference curve.
• The shape of the Offer Curve should be noted carefully. It starts at the origin, lies completely above the autarky price ratio and has an ever increasing slope. The ever increasing slope shows that to induce more exports requires ever increasing returns in terms of imports. This is because of the underlying assumptions of a rising MRT and a diminishing MRS.
• The position of the offer curve is determined by the positions of the demand and supply curves in the domestic wheat and cloth markets. Any changes in any demand parameters or any supply parameters will cause a rotation of the offer curve. The easiest way of thinking of this is to recognise that the offer curve sits on top of the autarky price ratio, and any change in Pw and/or Pc will cause a change in the autarky price ratio and so in the position of the offer curve.
For example a good wheat harvest that results in a rightward shift of SwA will result in a lower Pw and so cause a rightward rotation of the offer curve.
A successful advertising campaign for wheat based cereals that causes a rightward shift of DwA will result in a higher Pw and so cause a leftward rotation of the offer curve.
Diagrams 5.3A, 5.3B and 5.3C. At different world prices ratios we can see the amount of trade Taiwan is willing to enter into.
By plotting the information contained in the above diagrams we can generate the
Taiwanese Offer Curve.
The Taiwanese Offer Curve.
Taiwan’s Offer Curve can be derived in an analogous manner to the Australian Offer Curve.
The same points could now be made about the Taiwanese Offer Curve except in terms of shape. It starts at the origin, lies completely below the autarky price ratio and has an ever decreasing slope. The assumptions of a rising MRT and a diminishing MRS explain why this must be the case.
Back To The TOT.
We can now put the two Offer Curves together on the same diagram and look at the forces that determine the equilibrium world price ratio.
The two offer curves identify the unique equilibrium world price ratio where both countries “offers” coincide and a balanced trade outcome is achieved.
The diagram shows that there are a range of possible world price ratios that allow two way trade to take place. These all lie between the autarky price ratios. There is however only one world price ratio which is consistent with a coincidence of “offers”. This is the equilibrium world price ratio defined by the intersection of the two offer curves.
We have given the equilibrium world price ratio a value of 1 in our diagram. At that price ratio the amount of wheat Australia wants to export coincides with the amount of wheat Taiwan wants to import and the amount of cloth that Taiwan wants to export coincides with the amount of cloth Australia wants to import.
At any other world price ratio trade is not balanced and so an adjustment process would be triggered leading to a change in the worlds price ratio towards its equilibrium level.
For example, at a world price ratio of ½ we see an ED in the world wheat market and an ES in the world cloth market, these result in upward pressure on Pw and downward pressure on Pc, thus the world price ratio increases towards its equilibrium level. The price changes lead to changes in “offers” and the process continues until trade is balanced.
If the world price ratio was 2 then the adjustment process would be triggered in the opposite direction.
This can be seen by looking at the offer curves or by looking at the underlying transformation frontier diagrams.
Offer curves are determined by demand and supply conditions in both markets in both countries. Their intersection in effect defines the equilibrium TOT or world price ratio at which balanced two way trade occurs. This is the price ratio where each country’s
At any other world price ratio we would not have an equilibrium outcome in that trade would not be balanced. An adjustment process would be triggered in these circumstances that pushes the actual world price ratio towards its equilibrium level.
A very important final note is that we should recognise that any change in either country’s demand or supply conditions in either their wheat or cloth markets will cause a change in the position of at least one of the offer curves and so there will be an adjustment process triggered that will move the world price ratio to a new equilibrium level will shift
A Return To Demand and Supply.
We can now change our focus and use partial equilibrium analysis to look at the determination of the equilibrium TOT and later at the efficiency conditions and welfare implications of free trade.
We can do this by looking at the market conditions for wheat in Australia and Taiwan, and then as a separate exercise the market conditions for cloth in Australia and Taiwan. From these domestic markets we can then derive the world market for wheat and the world market for cloth. This in turn allows us to focus on the determination of the world price of wheat and the world price of cloth and so ultimately on the determination of the world price ratio.
The World Wheat Market.
Australia “World” Taiwan
The world wheat market is derived from the two domestic wheat markets. The world price of 62 wheat and the quantity of wheat exchanged internationally are both determined here. Note that W1=(W1-W2)A=(W2-W1)TS.
Starting with the Australian domestic market we would expect the Australian autarky price to be relatively low given our assumptions about demand and supply conditions. The autarky price is of course consistent with equilibrium in the domestic market where production and consumption levels coincide as they must under conditions of no trade. Following from our analysis so far we can give the autarky price ratio a value of 1/4.
If we then look at the Taiwanese wheat market we would expect the autarky price to be relatively high given our assumptions about demand and supply conditions. The autarky price here will also be consistent with an equilibrium outcome in the domestic market. Following from our analysis so far we can give the autarky price ratio a value of 4.
We should note that the price of wheat shown in the diagrams is the relative price of wheat as it is expressed in real terms. We should also note the consistency of the demand and supply curves with the assumptions made in our general equilibrium diagram.
When we allow trade we would expect to see the Pw rise from the Australian perspective and fall from the Taiwanese perspective.
Focussing on the Australian situation we can see that any increase in Pw above its autarky level will generate an excess supply in the domestic wheat market. This becomes an exportable surplus and allows us to derive the supply schedule of exports in the world market.
The shape and the position of the supply of exports is directly determined by domestic market conditions in the exporting country. It does not exist except in the context of the Australian domestic market.
Focussing then on the Taiwanese situation we can see that any decrease in Pw below its autarky level will generate an excess demand in the domestic wheat market. This becomes a demand for imports to fill the domestic demand gap and allows us to derive the demand schedule for imports in the world market.
The shape and position of the demand for imports is also directly determined by domestic market conditions in the importing country. It does not exist except in the context of the Taiwanese domestic market.
Now that we have the world market for wheat we can see that if world supply and world demand are allowed to interact then a market clearing world price for wheat will be established.
We have given this equilibrium world price ratio a value of 1.
We can see that at this price ratio the production and consumption outcomes in each domestic market and that the resulting excess supply in the Australian exportables market matches the resulting excess demand in the Taiwanese importables market. Each domestic market and the world market are in balance. We have a balanced two way trade outcome.
At any other world price ratio we can see that the outcome in the world market would not be balanced and so an adjustment process would be triggered. The adjustment process would push the world price ratio back towards its equilibrium level.
For example, at a (Pw/Pc)*=2 we see an ESw in the world market because the ESwA is greater than the EDwT. This will result in downward pressure on Pw relative to Pc and so downward pressure on Pw/Pc. The process will continue until the equilibrium world price ratio is re-established.
The World Cloth Market.
Australia “World” Taiwan
Diagram 5.7The world cloth market is derived from the two domestic cloth markets. The world price of cloth and the quantity of cloth exchanged internationally are both determined here. Note that C1=(C2-
You should be able to repeat the same process for the derivation of D and S in the world cloth market and so explain the forces that determine Pc/Pw.
Partial Equilibrium Efficiency Conditions.
We can now introduce the partial equilibrium efficiency conditions. These require the use of the concepts of Marginal Cost and Marginal Evaluation.
The efficiency condition under conditions of competition in production requires that
The efficiency condition under conditions of competition in consumption requires that P=ME.
When there are multiple production points the efficiency condition is that MC=MC.
When there are multiple consumption points the efficiency condition is that ME=ME.
We can relate MC and ME to our diagrams and show that free trade is efficient from both country’s points of view.
The height of the S schedule at any given production point represents the MC of production at that point.
The height of the D schedule at any given consumption point represents the ME of consumption at that point.
If we look at the world wheat market we can see that at the autarky production and consumption points we had an efficient outcome in each country but that between countries the MC’s were not equal nor were the ME’s equal. So while there was domestic efficiency there was not an efficient allocation of the worlds resources in terms of the production mix across countries nor in terms of the consumption mix across countries.
If we then look at the free trade outcome we see that free trade has not just generated gains to both countries it has in fact provided an outcome where we have the most efficient possible production mix and the most efficient possible consumption mix across the world market. This is seen by noting that the free trade outcome shows that at the respective production and consumption points MAA=MEA=MCT=MET. There is no possible way of improving the allocation of the worlds resources in terms of production and no possible way of improving the allocation of the resulting output in terms of consumption. Free trade has not just increased world welfare it has in fact maximised world welfare.
The same outcome can be demonstrated in the cloth markets.
The Welfare Implications Of Free Trade.
Both countries can be shown to gain from trade in welfare terms in the partial equilibrium setting.
We can use consumer and producer surpluses to show that this is true. Consumer surplus and producer surplus are measures of society’s welfare. They change as we move from no trade to free trade and by looking at the change we can see whether society’s welfare has increased or decreased.
We need to understand exactly what consumer and producer surplus represent before we apply them to our trade story.
Consumer surplus can be measured by comparing the area under the demand curve with the area under the price line at any given price-quantity outcome.
We treat the height of the demand curve at any consumption unit as a representation of marginal evaluation because it shows the price an individual is prepared to pay for that unit of that commodity and so must reflect the benefit they expect to receive.
Logic says that no-one is going to pay a price that is higher than the benefit they expect to receive.
Since the height of the demand curve represents a consumers marginal evaluation of any given consumption unit, the sum total of the areas under the demand curve must represent the benefit to society from the consumption of that quantity of that commodity.
In comparison the total cost to society of consuming any quantity of any commodity is simply the per unit price multiplied by the number of units or the area under the price line over the consumption range.
Consumer surplus is a measure of society’s welfare. It is the benefit
consumers receive free of charge. It is the difference between total benefit (area ABCE) and total cost (area FBCE) and is represented in this diagram by the area ABF.
By comparing these two areas we see that consumers receive a benefit from consumption that is greater than the price they pay. This excess of benefit over cost is the benefit consumers receive free of charge. It is referred to as the consumer surplus. We use it as a measure of society’s welfare.
Producer surplus can be measured by comparing the area under the price line with the area under the supply curve at any given price-quantity outcome.
We treat the height of the supply curve at any given production unit as the marginal cost or the resource cost to society associated with the production of that unit. The sum of the marginal costs over a given production range therefore represents the total resource cost to society of producing that quantity of that commodity.
In comparison the total revenue received by the producers is simply the constant per unit price multiplied by the number of units or the area under the price line over the production range.
Diagram 5.9Producer surplus or economi c rent is a measure of society’s welfare. It is the benefit producers receive from the act of production. It is the difference between society’s cost of production (area G B C E) and producers receive (area F B C E) and is represented in this diagram by the area GBF.
By comparing these two areas we see that there is an excess of revenue over cost. This is what is referred to as the producer surplus. It is also used as a measure of society’s welfare.
The producer surplus is often referred to as the economic rent in production.
The Welfare Implications Of The Movement To Free Trade.
We can now compare consumer surplus and producer surplus in the no trade world and in the free trade world. We will focus on the wheat market.
Diagram 5.10The movement from no trade to free trade generates an increase in welfare in Australia of area
JKB (which equals area 1 in size) and an increase in welfare in Taiwan of area MNR (which equals area 2 in size). The world welfare has increased by area 1 plus area 2.
From the Australian perspective we can see the following outcomes.
• With no trade the consumer surplus was ABF. With free trade the consumer surplus is AJH. There has been a decrease in consumer surplus given by the difference in these two areas which is HJBF.
• With no trade the producer surplus was FBC. With free trade the producer surplus is HKC. There has been an increase in consumer surplus given by the difference in these two areas which is HKBF.
• Society is worse off by the loss of consumer surplus HJBF, and society is better off by the increase in producer surplus HKBF. If we net out the gains and losses we see that overall society gains by the difference between these two areas which is JKB.
From the Taiwanese perspective we can see the following outcomes.
• With no trade the consumer surplus was LMV. With free trade the consumer surplus is LNT. There has been an increase in consumer surplus given by the difference in these two areas which is VMNT.
• With no trade the producer surplus was VMS. With free trade the producer surplus is TRS. There has been a decrease in producer surplus given by the difference in these two areas which is VMRT.
• Society is better off by the gain of consumer surplus VMNT, and society is worse off by the decrease in producer surplus VMRT. If we net out the gains and losses we see that overall society gains by the difference between these two areas which is MNR.
From the perspective of the world market we can see the following outcomes.
• When there was no trade there was no consumer surplus in the world market. When trade is allowed a consumer surplus given by area 1 is created. The world is better off by this amount which accrues to the importing or consuming country. This area must therefore be equal in size to the Taiwanese gain of MNR.
• When there was no trade there was no producer surplus in the world market. When trade is allowed a producer surplus given by area 2 is created. The world is better off by this amount which accrues to the exporting or producing country. This area must be equal in size to the Australian gain of JKB.
• The world as a whole is better off in a welfare sense by areas 1 plus 2. These in total must equal the sum of the Australian gain and the Taiwanese gain, that is areas JKB plus MNR, because our world is made up of only two countries.
Overall we see that each country gains in a welfare sense from the trade process and that the world as a whole also gains.
The distribution of the gains can be seen by the size of the respective triangles. These will change as domestic demand and supply elasticities change. There is no reason to believe that countries will gain equally from the trade process.
For example, the less elastic are the Australian domestic demand and/or domestic supply curves then the less elastic is the world supply of exports curve and so the greater are the gains accruing to Australia because the free trade price is further away from the autarky price.
The Cloth Market.
Australia “World” Taiwan
Diagram 5.11Australia’s gain s are represented by ABC or 1 and Taiwan’s gains are represented by EFG or 2.
You can repeat the exercise for the cloth market.
From the Australian perspective the net gain is area ABC.
From the Taiwanese perspective the net gain is area EFG.
The world gains by areas 1 plus 2.
Note that ABC must correspond to 1, and that EFG corresponds to 2.
In a partial equilibrium setting we can look at the determination of the world prices and hence the world price ratio. Again it is apparent that it is the domestic market conditions in each market in each country that shape the world markets and hence the world prices.
We can also see that free trade is efficient by introducing and applying the standard efficiency notation.
Further than that we can use our understanding of consumer and producer surplus to again demonstrate that free trade provides benefits to all participating countries.
The Heckscher-Ohlin Model.
While we have explored the trade model in some detail we as yet have said very little about two important issues. The first is the question of where the comparative advantage comes from. The second is what are the implications of free trade for the internal distribution of income. We need therefore to extend our model backwards and forwards.
This can be achieved by introducing the Heckscher-Ohlin Model which formally looks at the major reason for the existence of comparative advantage. We can then look at the Samuelson extension of the H-O Model to begin our discussion of internal income distribution.
Note that the superstructure that we have been working on for some time is essentially built on the H-O foundations.
Where Does The Comparative Advantage Come From ?
The basis of our trade model has been the identification of a difference in autarky price ratios between countries. If autarky price ratios were different we could define a comparative advantage and build our model accordingly.
An important question is the why do pre-trade price ratios differ between countries ?
There can be many contributing factors ?
1. different patterns of income distribution
2. differences in technology
3. different climates
4. differences in education
5. different age structures
6. differences in the make-up of the labour force
7. differences in research and development expenditure
8. differences in the tendency to innovate
9. differences in tastes and preferences
10. different stages of development
11. differences in the quality of raw materials
12. differences in the availability of “land, labour and capital”
Any or all of these could provide the basis for the trade model that we have constructed.
We need to isolate the most important reason or reasons as to why autarky price ratios would be expected to be different.
This is essentially an empirical question and the major work was undertaken by Heckscher (1919) and Ohlin (1931).
There conclusion was that the most important single reason for the difference in autarky price ratios was a difference in relative factor endowments between countries.
This proposition has been tested extensively since that time and has been proven to be correct.
We can now look at the H-O model in some detail.
The H-O Model is based on a series of assumptions which we can bring together here.
1. It is a 2x2x2 model which means that our world is assumed to be made up of 2 countries, 2 commodities and 2 factors of production. This is a simplifying assumption and our conclusions are generalisable to any number of countries, commodities and/or factors.
2. Technology is assumed to be identical between countries. One implication of this is that we would expect profit maximising producers in each country to use more of its relatively cheap factor of production so as to minimise costs of production.
3. We assume constant returns to scale in both commodities in both countries. This simply means that if we double the factor inputs we get double the output as a result.
4. There is incomplete specialisation in production because of rising opportunity costs in production. So both countries before and after trade produce some quantity of both commodities.
5. Tastes and preferences and the distribution of income are assumed to be the same in both countries. This implies that demand patterns are the same and so indifference curve maps are identical. The result of this is that when relative prices are equal for both countries then so too will relative consumption bundles be equal for both countries.
6. Perfect competition is assumed in all product and all factor markets. This means that no-one has any market power, there is perfect knowledge, homogeneity of products and factors, and that maximising behaviour determines all actions.
7. There is perfect factor mobility within countries but not between countries. So factors are freely mobile within a country but there is no international migration of factors allowed. This implies that we are operating in the long run and that wage rates between sectors will be equalised within countries but not between countries when there is no trade.
8. Free trade between these countries is assumed. There are no transport costs, tariffs, or other obstructions to the free flow of goods and services. The end result of specialisation and trade will therefore be an equality between relative price ratios.
9. Full employment of all factors of production in both countries is assumed both before and after the movement from no trade to free trade.
10. When we allow trade the result will be a balanced trade outcome.
11. Australia is assumed to be relatively labour abundant and Taiwan is assumed to be relatively capital abundant.
This simply means that (SL/SK)A > (SL/SK)T.
From the Taiwanese perspective this also means that (SK/SL)A < (SK/SL)T.
12. In both countries we assume that wheat is the labour intensive commodity and that cloth is the capital intensive commodity.
This means that wheat requires a lot of labour relative to capital to produce efficiently and that cloth requires a lot of capital relative to labour to produce.
This can be shown as (L/K)wA > (L/K)cA and that (L/K)wT > (L/K)cT for given relative factor prices..
The H-O Model is a general equilibrium model in that it recognises all the variables that can contribute to the existence of a comparative advantage but it isolates different factor endowments between countries as the major cause of different factor prices and therefore of different relative commodity prices.
It sees relative factor endowments as the main explanatory variable in the existence of differences in autarky price ratios.
We can look at the role of factor endowments in this overall model of the determination of autarky price ratios.
The model can be set out as shown below.
Tastes and preferences Equal
The distribution of income Equal
Revealed demand for goods and services Equal
Derived demand for factors of production Equal
Supplies of factors of production Not equal
Factor prices Not equal
Product prices Not equal
Comparative Advantage In More Detail.
We have said that Australia is relatively labour abundant.
This means (Total SL/Total SK)A > (Total SL/Total SK)T
Which implies that (PL/PK)A < (PL/PK)T
Or that (w/r)A < (w/r)T within the context of the assumptions made.
Why is this the case?
This must be the case because the first expression is based on purely supply side considerations while the second statement is based on both supply and demand considerations.
It follows that since we have assumed a common demand side in both countries which implies common derived factor demands, then differences in factor supplies must result in differences in factor prices.
In particular the country with the relatively large factor supply must be the country with the relatively low factor price.
Since we have assumed that Australia is relatively labour abundant it follows that therefore it has a relatively low price for labour.
It also follows that Taiwan being capital abundant must have a relatively low price for capital.
It Then Follows Logically …
It then follows logically that to minimise production costs we would expect each country to extensively use its abundant or cheap factor.
So we would expect Australia to produce more labour intensive goods (i.e. wheat) and Taiwan to produce more capital intensive goods (i.e. cloth).
Production Possibility Curves Again.
This information can then be related to each country’s PPC.
We know that :
• Wheat is Labour intensive and Cloth is Capital intensive, and
• Australia is Labour abundant and Taiwan is Capital abundant
therefore we can therefore suggest that Australia can produce relatively more wheat and relatively less cloth, while Taiwan can produce more wheat and less cloth.
Diagram 6.1The Australian and the Taiwanese Production Possibility curves reflecting their relative factor abundances and the relative factor intensities of wheat and cloth production.
We should recall that we have assumed that tastes and preferences and the distribution of income for each country are assumed to be identical and so a single indifference curve map can be used to represent the demand side of both economies.
We could draw one indifference curve representing both countries on our PTF diagram and by looking for the tangencies we can define the autarky equilibriums. Note that the autarky equilibriums suggest autarky price ratios where (Pw/Pc)A < (Pw/Pc)T.
Diagram 6.2Assuming only difference in factor supplies the resulting autarky equilibrium at point A for Australian and point X for Taiwan suggest autarky price ratios such that
This pattern of autarky price ratios is what we should expect based on our assumptions concerning factor endowments and factor intensities.
In each country the abundant factor is the cheap factor and it follows that the good that uses the abundant factor intensively in the production process will be the cheap good in a relative sense.
Since Australia is relatively labour abundant and wheat requires a relatively labour intensive production process we would expect that PwA would be less than PwT.
Also, since Taiwan is relatively capital abundant and cloth requires a relatively capital intensive production process we would expect that PcA would be greater than PcT.
Putting these two observations together it follows that we would expect to see that (Pw/Pc)A would be less than (Pw/Pc)T.
This allows us to identify the comparative advantage held by each country and so we could continue on and construct our familiar trade model.
Note that the existence of the comparative advantages are based solely here on differences in factor endowments between countries.
We have already identified the autarky equilibriums.
We can note that Australia has a comparative advantage in wheat and Taiwan has a comparative advantage in cloth.
We can now allow specialisation in production and exchange in the international market place and move to the free trade equilibriums where both countries clearly gain from the trade process and in fact where world welfare is maximised.
The free trade equilibriums show both countries gain from trade based on a comparative advantage generated from a difference in factor endowments.
At this point we could use our diagrams to focus on all of the areas we have already discussed. The point here though is that we now have some knowledge of the source of the comparative advantage which these trading nations are exploiting.
The Internal Distribution Of Income.
The other area that we have not focussed on is the consequences of the movement from no trade to free trade on the internal distribution of income within a country.
The Heckscher-Ohlin Model allows us to focus on the long run outcomes and so we can develop the Factor Price Equalisation Theorem for that purpose. To analyse the short run impact we will however have to again change focus and develop the Specific Factors Model.
The Relative Factor Price Equalisation Theorem.
The Relative Factor Price equalisation Theorem can be developed from the extensions to the H-O Model introduced by Samuelson in the 1950’s.
Samuelson argued that free trade will in goods and services will bring about equal relative factor prices across countries.
In effect he saw free trade in goods and services as being a perfect substitute for perfect international factor mobility.
We have assumed away the possibility of international migration of labour and capital. If there was perfect international mobility of factors of production we would expect to see the market generate a common world price for labour and a common world price for capital. Since we do not have international; factor mobility this will not necessarily be the case.
If we have free trade in goods and services however we would expect to see the establishment of a common world price ratio for wheat and cloth. Since the differences in autarky price ratios in the H-O framework are due to differences in factor price ratios caused by differences in factor endowments, it follows that the end result of free trade in goods and services will be the establishment of a common world factor price ratio.
We can explain this in more detail by starting with the autarky price ratios for Australia and Taiwan and working through the impact of the trade process on product price ratios and on factor price ratios.
• At autarky (Pw/Pc)A < (Pw/Pc)T because (w/r)A < (w/r)T.
• If we now allow trade to take place we will see Australia according to its comparative advantage produce more wheat and less cloth.
Since wheat is labour intensive an increase in wheat production will result in a large increase in the demand for labour and a small increase in the demand for capital.
Since cloth is capital intensive a decrease in wheat production will result in a small decrease in the demand for labour and a large decrease in the demand for capital.
The overall result then will be an increase in the demand for labour and a decrease in the demand for capital in Australia.
This means that we would expect to see upward pressure on wA and downward pressure on rA and so (w/r)A would be expected to increase.
• The opposite outcome will be seen in Taiwan where we would expect to see (w/r)T decrease.
• So trade in goods and services not only pushes the (Pw/Pc)’s together, it also pushes the (w/r)’s together. Since the end result of free trade in goods and services is the establishment of a common world product price ratio it follows logically that it also results in the establishment of a common world factor price ratio.
Internal Income Distribution.
Our conclusion is therefore that free trade in goods and services is a perfect substitute for international factor mobility because it has the same effect on relative factor prices. This is important because we can now relate the trade outcome to domestic income distribution outcomes.
We can start by asking what is the impact on labour and capital income within a country when that country moves from an autarky outcome to a free trade outcome ?
Since we have assumed full employment of all factors of production both before and after the move to free trade then the movement in the factor income accruing to any factor class will be reflected in the movement of the factor price for that factor class.
We have seen the price of the abundant factor in both countries increase and the price of the scarce factor in both countries decrease.
In Australia labour is the abundant factor and so labour income rises. Capital is the scarce factor and so capital income falls.
The opposite is true in Taiwan. Taiwan is capital abundant and so capital income rises. It is labour scarce and so labour income falls.
So there is a redistribution of income in the long run in each country away from the scarce factor and towards the abundant factor.
We should note that the country as a whole though is still better off so the gainers could compensate the losers and still gain themselves. For this outcome to be realised we would need to see the development of an appropriate redistribution policy. This could involve the taxation system, the social security system, labour market retraining policies etcetera.
One of the implications of this outcome is that it helps to explain why unions in developed countries generally favour trade restrictions. Since developed countries tend to be capital abundant a movement toward free trade results in a redistribution of income away from the workers that the unions represent.
What About The Short Run ?
We can turn our attention to the specific factors model to focus on the short run implications of the movement to free trade for the internal distribution of income.
The factor price equalisation theorem above assumes all factors of production are mobile within a country. While this is true in the long run it is not true in the short run.
We can modify our conclusions by looking at the specific factors model which is explicitly a short run model.
The Specific Factors Model.
We will take the Australian perspective and start by setting out the assumptions of the model.
• It is a 2x2x2 model. This means that we will have 2 countries (Australia and Taiwan), 2 commodities (wheat and cloth), and 2 factors of production (labour and capital).
• Since we are taking the Australian perspective we treat wheat as the exportable sector and cloth as the importable sector.
• Of the 2 factors of production it is assumed that labour is the variable factor and as such is freely mobile between the wheat and the cloth sectors. On the other hand capital is assumed to be fixed within a particular industry and as such is industry specific for the duration of the analysis.
The relationship between inputs and output is summarised by the law of diminishing Marginal Productivity.
• Perfect competition and all that it implies is assumed to hold true for all markets.
This implies that there will be a common wage rate across the Australian economy and that employment in each industry will be such that w=MRPL and r=MRPK.
• Australia is a small country and so is a price taker in world markets.
• Full employment of all factors of production is assumed before and after the movement to free trade.
< Total SLA >
The Specific Factors Model shows the initial allocation of the variable factor between the wheat and the cloth sector in Australia and the common wage rate.
By applying our knowledge of factor market analysis we can construct the specific factors diagram and show the allocation of the variable factor between the wheat sector and the cloth sector under conditions of no trade.
Students should be able to comment on the meaning, the shape and the position of the MRP schedules. Then by explaining the common wage outcome and the profit maximising employment rule they should be able to explain the no trade allocation of labour between sectors remembering the assumption of full employment.
The outcome as shown has 0wL0 units of labour employed in the wheat sector and 0cL0 units of labour employed in the cloth sector. The sum of 0wL0 and 0cL0 equals the total available labour supply in Australia which is the width of the box.
If we then allow trade to take place, since Australia is labour abundant and wheat is labour intensive Australia will have a comparative advantage in wheat production and specialise accordingly.
The result of this will be an increase in Pw from the Australian perspective and so an increase in the MRPL in the wheat sector in Australia. The size of the price increase can be measured by the distance AB.
To produce more wheat producers need to employ more of the variable factor labour, and the increase in the MRP allows them to bid up the wage rate to attract additional units of labour while still remaining profit maximisers. Employers in the cloth sector must match the wage increase and shed labour to increase their MRPL.
The impact of the movement from no trade to free trade on the allocation of the variable factor between sectors.
The new equilibrium is achieved with an allocation of labour such that 0wL1 are employed in the wheat sector and 0cL1 are employed in the cloth sector. Full employment has been maintained but there is a greater level of employment in the comparative advantage wheat sector and a lower level of employment in the comparative disadvantage cloth sector.
While there has been a reallocation of labour capital has remained industry specific.
There is also a new higher common wage rate across both sectors given by w1. The increase in the wage rate is captured by the distance BC.
The Short Run Income Distribution Outcome.
We are now in a position to use the Specific Factors Model to comment on the implications for the internal distribution of income in the short run of a movement from no trade to free trade.
From the labour perspective we can see that the wage rate for all workers has increased. Whether consumers are better off though depends on product price changes relative to the wage change.
The price of wheat has increased by a greater amount (AB) than the increase in the wage rate (CB). But the increase in the wage rate is greater than the increase in the price of cloth which we have left unchanged.
Consumers whose preference patterns favour wheat are therefore worse off in real terms. Consumers whose preference patterns favour cloth are however better off in real terms.
So unlike the long run where labour, the abundant factor in Australia, was unambiguously better off, in the short run the outcome for labour depends on consumption patterns.
The outcome for the owners of capital is also more complex in the short run. Since there has been a reallocation of labour toward the wheat sector and away from the cloth sector the capital that is specific to each industry will be utilised differently than before trade was allowed.
In the expanding wheat sector the capital stock will be used more intensively. As a result it will be more productive and the resulting increase in the MRPK will mean that the owners of capital in that sector will command a higher price for their factor.
The opposite is true in the contracting cloth sector.
So the outcome for the owners of capital in the short run is also different than in the long run. In the long run capital was the scarce factor and was unambiguously worse off. In the short run however it depends on in which industry the capital is domiciled as to whether it is better off or worse off.
We have built a complete model of international trade that shows trade generates benefits to all participating countries.
It is a general model in that it takes account of all possible relevant variables.
It is a flexible model in that we can change all of the assumptions on which it is built.
It is a practical model in that it explains a large proportion of observed international trade flows. After extensive testing over many years its empirical relevance has been firmly established.
Complementary trade theories are however needed to explain, for example, intra industry trade which the H-O Model is not able to do.
Newer models that complement our work but are based on imperfectly competitive markets and on economies of scale have been developed to deal with those parts of observable trade outcomes that are not explained by our model.
Intervention In The Trade Process.
We have seen that free trade provide benefits to all countries that participate, and that further than that it in fact maximises world welfare.
But in the real world we see extensive intervention in the trade process.
We should ask why this is the case ?
There are many arguments presented to attempt to justify intervention but when we analyse them we see that they generally fall into two general categories of argument.
The Pursuit Of An Objective…
The first group of arguments are those that oppose free trade because of a concern with achieving another objective.
There are many other objectives that individuals or groups pursue.
• A concern with self-sufficiency for survival and/or defence purposes.
• A desire to protect the interests of a particular group such as farmers who want a weaker currency to maintain exports.
• A desire to generate a particular pattern of income distribution within the economy.
• Concerns with job diversification and/or industry diversification and/or avoiding technological redundancy.
• A concern with other economic objectives such as job creation or easing a trade deficit problem or fostering new industries.
• A desire for retaliation against other countries or to impose sanctions against other countries.
All of these concerns or objectives are influenced by the extent and the type of intervention in the trade process either directly or indirectly. They are all arguments used to attempt to justify intervention.
It is not our place to comment on the objective. However once we have a stated objective we can legitimately ask whether intervention in the trade process is the best way of achieving that objective. We can apply our analytical tools to identify the costs and/or the benefits of using trade policy to pursue that objective.
Typically what we will find is that intervention in the trade process helps achieve the stated objective but at a cost to society. We will also typically find that given the stated objective there is a better or more direct or less costly policy available.
The Assumptions Of The Model…
The second general group of arguments are based around concerns with the assumptions made in building the free trade model. They typically argue that since the assumptions are not realistic the conclusions generated are not acceptable. The extension of the argument is that the assumptions in fact generate the conclusions.
We can look at some of the assumptions made and see whether they do in fact drive the conclusions generated.
So for example, we can look at situations where there is less than perfect competition, or where there are externalities, or at large countries rather than small countries involved in the trade process. In each case our concern will be whether the conclusions of our free trade model need to be changed because of the change in assumption.
General Overview Of Commercial Policy.
Our concern is now with intervention in the trade process or what is formally called the theory of commercial policy.
We will start with a general overview of intervention and its effects before looking at specific arguments that are used to attempt to justify intervention..
There are many types of trade restriction. A brief list would include the following.
• non tariff barriers such as license requirements, design standards and content regulations
• voluntary export restraints
• export subsidies
• anti-dumping duties
• trade blocs which involve discriminatory barriers
The restrictions used can be price restraints and/or quantity restraints.
They can be imposed to restrict imports and/or to promote exports.
They can be uniform in nature or discriminatory in nature.
They can be imposed or negotiated.
We will focus on tariff restrictions to protect the domestic import competing industries in a small country setting.
Why do we take this focus ?
Firstly all other forms of trade restrictions have tariff equivalents that can be shown to be more costly to society than the tariff.
Secondly export protection analysis provides the same conclusions as import protection analysis.
Thirdly the small country partial equilibrium perspective is the most relevant to take in terms of the real world and we can change the focus to that of a large country when necessary.
A tariff is simply a tax levied on a good as it crosses a national boundary. It is typically passed on to consumers in the form of a higher price for the product.
The tariff can be specific, ad valorem, or compound.
We will focus on a specific or per unit tariff.
We can start by recalling the general equilibrium free trade diagram for Australia.
The general equilibrium diagram which shows the no trade and free trade equilibrium for both the wheat and the cloth markets in Australia.
From this we can derive the partial equilibrium domestic cloth market because cloth is the comparative disadvantage or importable commodity. The autarky equilibrium price is P0 and at this price domestic production is at C0 and domestic consumption is at C0.
This is because in a partial equilibrium sense efficiency in production requires production at the level where P=MC and efficiency in consumption requires consumption at the level where P=ME.
The domestic cloth market can be abstracted from the general equilibrium diagram.
The Imports Market.
We can then also derive the import market from the Australian perspective.
Begin with the demand for imports from the Australian perspective. At any price below P0 we see an excess demand for cloth in Australia. This manifests itself as a demand for imports to fill this domestic demand gap.
The Australian demand for imports derived from the domestic cloth market.
Now the supply of imports to Australia. Remember we assume Australia is a small country in the context of the world cloth market. This means that it has no market power. It is a price taker in the world market. This implies that Australia faces a perfectly elastic supply curve of imports from the rest of the world at a price determined in the world market. The price determined in the world market is P1 and Australia can import as much as it likes at this price.
The world cloth market and the supply of cloth imports from the
The Free Trade Equilibrium.
By bringing the domestic market, the demand for imports and the supply of imports together we can look at the free trade outcome from the Australian perspective. Note that the world price determined in the world market becomes the domestic price faced by consumers and producers.
The free trade outcome from the Australian perspective.
The free trade outcome from the Australian perspective is therefore at price P1 determined in the world market where domestic producers produce C1, domestic consumers consume C2, and where Australia imports the difference C* which by construction is C2 – C1.
We can now combine the domestic importables market and the imports market into one diagram to focus on the effects of intervention in the trade process.
The Australian importables market combines all of the information from the domestic and “world’ markets.
The free trade outcome is exactly the same as above but we can represent this in a single diagram.
The Imposition Of A Tariff.
Now, starting with the free trade outcome we can ask a general question. If for whatever reason, possibly a pressure group representing the manufacturing sector which lost in the movement to free trade putting pressure on the government and the government responding to this pressure for political reasons, the objective in this industry is to increase domestic output from C1 to C3, what is the best way to achieve this objective ?
A common choice of policy has been to implement a tariff. A tariff is a tax on imports as they cross a national boundary. It is typically passed on to consumers in the form of a higher price and so allows domestic producers of the import substitute to produce and sell their output at a higher price and still be competitive against imports.
The outcome of the tariff can be shown diagrammatically.
Diagram 7.7The impact of an import tariff on domestic production and domestic consumption.
The imposition of the tariff raises the S* schedule by the amount of the per unit tariff. Note that importers still pay P1 per unit for the import commodity in the world market but then pay the tariff / tax per unit of imports to the Australian government. The price faced by consumers for the import is the tariff inclusive price of P2. Australian producers can then charge a price P2 for the domestically produced import substitute and still be competitive.
The outcome after the tariff is then a price P2 with domestic production at C3, domestic consumption at C4, and imports of C4 – C3.
The Tariff Is Successful But…
Note that the tariff is successful in achieving the stated target of increasing domestic production to C3 and improving the outcome for the Australian producers of manufactured commodities.
But the success has come at a cost and we can suggest there is a better way of achieving the stated objective that imposes a smaller cost.
In this sense we are arguing that intervention in the trade process in a general sense is not economically justified.
We need to identify the costs and we will do so by again using consumer surplus and producer surplus as measures of society’s welfare.
We need then to be able to demonstrate that there is abetter, more direct, and less costly policy available.
We have already defined and explained consumer surplus and producer surplus.
We can use them to compare the free trade and the restricted trade outcomes and to comment on the welfare outcomes for the country arising from the imposition of the tariff.
DConsumer and producer surpluses can be used to focus on the welfare effects iagram 7.8 of the imposition of a tariff.
We can look at the change in consumer surplus, the change in producer surplus, and the role of tariff revenue to comment on the outcome for society.
The free trade consumer surplus is ACH.
The restricted trade consumer surplus is ABJ.
There has been a loss of consumer surplus of JBCH
This loss is made up of JKFH+KEF+KBDE+BCD.
The free trade producer surplus is HFG.
The restricted trade producer surplus is JKG.
There has been a gain of producer surplus of JKFH.
There has been a gain of tariff revenue which we assume is spent efficiently and equitably on society’s behalf of KBDE.
By adding the loss of consumer surplus together with the gain of producer surplus and the gain of tariff revenue we see that in a net sense Australia is worse off by the areas of KEF plus BCD.
These areas are referred to as the deadweight loss triangles.
They represent the welfare cost to Australia as a whole of the imposition of a tariff to protect domestic producers of the import substitute.
So the tariff is successful in achieving its stated objective but it does so by imposing costs on society.
The Deadweight Losses Explained.
We can look at the losses in more detail.
The triangle KEF represents the deadweight loss due to the introduction of a distortion on the production side of the market. The tariff has caused domestic production to rise from the efficient level C1 to the inefficient level C3. The resource cost of importing these units was the sum of the Marginal Costs of importing over this range which equals FEC3C1. The resource cost of domestic production of these units is FKC3C1. The triangle KEF represents the wasted scarce domestic resources used to produce these units domestically instead of importing them.
The triangle BCD represents the deadweight loss due to the introduction of a distortion on the consumption side of the market. The tariff has caused domestic consumers to fall from the efficient level C2 to the inefficient level C4. The loss of consumer welfare is given by the sum of the Marginal Evaluations over the reduced consumption range which equals BCC2C4. The resource saving generated from reduced imports is given by the sum of the Marginal Costs of importing over this range which equals DCC2C4. The triangle BCD represents the loss of consumer welfare generated by the reduction in consumption caused by the reduction in imports.
Is There A Better Way ?
We can suggest that not only does the tariff approach impose costs on society but that at least part of these costs are unnecessary.
We can now look at a per unit production subsidy as an alternative policy and show that while it still imposes a cost on society the cost is smaller than that imposed by the tariff.
Diagram 7.10The welfare impact of an equivalent subsidy.
If we set the subsidy equal to what the tariff was then the subsidy inclusive price received by producers will equal the what the tariff induced price was. The price faced by consumers does not alter, that is, it is still the free trade price.
The outcome with the subsidy is therefore domestic production increasing to C3, domestic consumption unchanged at C2, and imports reduced from (C2-C1) to (C2-C3).
Producers are still receiving the same protection as with the tariff but this time consumers are not being affected.
We can show that the subsidy is a more direct and less costly policy by again using consumer and producer surplus.
There is no change in consumption and so no change in consumer surplus.
Producer surplus has again increased by JKFH.
The payment of the subsidy which requires tax revenues to be raised can be treated as a cost to society. It is represented by the area JKEH.
Overall society is worse off by the difference between the producer surplus gain and the cost of the subsidy, that is by the deadweight loss triangle KEF.
This is the same production distortion as with the tariff because the level of domestic production has been increased beyond its efficient level. But the production subsidy policy is designed to directly achieve the stated objective and does not have the additional consumption distortion.
The subsidy is a better, more direct and less costly policy than the tariff. In this general setting we have established a basic argument against the use of tariffs to achieve specific objectives. Tariffs are too broad in their impact to be effective.
Why do we see more tariffs than subsidies in the real world ?
• They are more hidden and therefore less obvious than subsidies.
• They become entrenched easily because they are not annually renewable as is the case with subsidy payments.
• They are seen to be self financing whereas subsidies require more tax revenue to be raised.
• The benefits of a tariff are concentrated but the costs of a tariff are dispersed.
We can look at the impact of the tariff and the subsidy using the marginal efficiency conditions.
Under conditions of free trade we see MCd=MEd=MC*.
With the tariff we see MCd=MEd>MC*.
With the subsidy we see MCd>MEd=MC*.
So the tariff has a production and a consumption distortion while the subsidy only has a production distortion. The subsidy is a more direct and less costly policy.
The Way Ahead.
We have shown that the tariff is essentially a tax on the consumers of the protected product. However the tariff has a far wider impact than that. The tariff is in fact a tax on all unprotected producers and on exporters. It imposes costs on everyone but the protected producers.
We need to look at the broader consequences of the tariff and we also need to look at the size of the distortions generated.
The Broader Consequences Of The Tariff.
Our analysis so far has suggested that the tariff is simply a tax on the consumers of the protected product. The deadweight loss diagram showed that the tariff increased the producer surplus, provided tariff revenue which benefited society, but caused a decrease in consumer surplus.
We can now turn our attention to the fact that the tariff is not just a tax on consumers of the protected product but is also a tax on all non-protected producers. The tariff actually harms everyone except the producers of the protected product.
Our approach here will be to use a general equilibrium diagram that shows some of the wider costs of the tariff in the non-protected sectors of the economy. The diagram is familiar to us as it is a variation of the Specific Factors Model diagram introduced during our discussion of the short run income distribution consequences of the movement from no trade to free trade. The movement this time will be from free trade to restricted trade.
The model assumes the following.
• We will take the perspective of Australia in our standard 2x2x2 model of the world.
• The Australian economy is made up of two sectors. These are the wheat sector and the cloth sector or in a broader sense the agricultural or exportables sector and the manufacturing or importables sector.
• The wheat industry is the labour intensive industry and the cloth industry is the capital intensive industry.
• We are operating in the short run where labour is mobile between sectors and capital is fixed within sectors or is industry specific. We also assume perfect knowledge and perfect homogeneity. These imply that a common wage rate will be generated between sectors.
• Full employment of all factors of production is assumed both before and after the movement from free trade to restricted trade.
• Perfect competition is assumed in all product and factor markets. Amongst the many implications of this assumption we should recognise that employment of factors of production will be consistent with the objective of maximising profit. This means in turn that labour will be employed until the MRPL = w, and that capital will be employed until the MRPK = r.
• Australia is a small country in both its importables and exportables markets.
Diagram 8.1 The free trade allocation of the total available supply of labour between the wheat sector and the cloth sector occurs where MRPLW =
The diagram consists of the demand for labour schedules in the wheat sector and the cloth sector turned to face each other and to have a width consistent with the total available supply of labour in Australia.
Since we have assumed full employment the total available supply of labour must be allocated between the two sectors. The free trade allocation can be determined by remembering that perfect knowledge and perfect mobility of labour ensure a common wage rate and that in each sector profit maximising behaviour ensures that MRPL will be set equal to the prevailing wage rate.
This suggests that by simply finding the intersection of the two MRP schedules we will have determined the initial allocation of labour between the sectors and that allocation will be consistent with full employment.
If we now impose a tariff to protect domestic cloth producers we can trace out the impact on the non-protected wheat sector.
The immediate impact of the tariff to protect cloth producers is an increase in the price of domestic cloth to the tariff inclusive price level.
Since by definition the MRPLC = MPPLC x PC we will see the MRPLC increase as the tariff induced price of cloth increases. This will result in an upward shift of the MRPLC schedule and a disturbance to the free trade equilibrium.
Diagram 8.2 The impact of a tariff put in place to
protect the cloth sector.
The size of the price increase induced by the tariff can be measured by the vertical distance between the two MRPLC schedules at the initial allocation of labour L0 between sectors. This is the distance AB.
The protected cloth producers want to increase domestic output behind the tariff wall. To do this they need to employ more of the variable factor of production in the short run. To employ more labour they need to bid up the wage rate to attract labour out of the wheat sector. The increase in the MRPLC enables employers in the protected sector to do this and still remain at a profit maximising level of employment.
Please note that as the wage rate is bid up in the cloth sector to attract more workers to enable an expansion of output the newly arrived workers will cause a decrease in the MPPLC and so a decrease in the MRPLC. This is represented in the diagram as a movement down along the MRPLC’ schedule to the left of point B.
Employers in the wheat sector to protect their labour pool will need to match the wage increase. This means that to remain in a profit maximising situation they will need to also engineer an equal increase in the MRPLW. To do this we need to recognise that by being a small country we have no influence over the price of our exportable commodity as its price is determined in the world market. The only way to increase the MRPLW is therefore to increase the MPPLW. The only way to increase the MPPLW in a world of diminishing Marginal Productivity is to decrease the level of employment.
In the non-protected wheat sector we therefore see a decrease in the level of employment and a movement up along the MRPLW to the left of point A.
The end result of this adjustment process is a new equilibrium with a higher wage rate of w1 that is common for both sectors and a new allocation of labour between sectors at L1 where the level of employment in the protected sector has increased and the level of employment in the non-protected sector has decreased.
The Welfare Implications…
In terms of the protected sector we see the tariff result in a higher level of employment and a higher level of output. Employers are paying a higher wage but the increase in the wage rate is not as large as the increase in their product price. Overall their producer surplus has increased as has been demonstrated in the deadweight loss diagram.
Diagram 8.3 The increase in producer surplus
in the protected sector
The outcome for the non-protected sector is different. We see a decrease in the level of employment and a decrease in the level of output. The employers are paying a higher wage rate but the important thing to note is that they cannot pass that on in the form of a higher price as in the protected sector. This means that they are producing less and there is a smaller surplus per unit of output.
This outcome could be shown by looking at the exportables market from the small exporting nations point of view.
Diagram 8.4 The decrease in producer surplus in the non-protected sector
The wheat market is the exportables market from the Australian perspective. Since Australia is assumed to be a small exporting country it faces a perfectly elastic demand curve for its exports at a price determined in the world market and expected to be above the autarky price.
If the free trade price is P1 then domestic production will be at W2 and domestic consumption will be at W1. The exportable surplus is therefore W2-W1.
The producer surplus in the wheat sector is the triangle ABC.
When the tariff is imposed to protect the cloth sector there are two important outcomes for the position of the domestic supply curve for wheat.
The position of the supply curve is determined by a range of position parameters.
Amongst these are the price of related goods and the price of factors of production. We see the price of cloth increase and this causes producers in the pursuit of profit to move out of the wheat sector and into the cloth sector. We also see the wage rat increase across both sectors.
Both of these changes in position parameters cause the supply schedule of wheat to shift to the left. Since there can be no change to the given world price of wheat the result is a decrease in the producer surplus in the non-protected wheat sector to the area AEF.
The shaded area represents the loss of producer surplus in the non-protected sector that results from the imposition of the tariff to protect the cloth sector. This shows that the impact of the tariff is not just to harm consumers of the protected product. It in fact also acts as a tax on all non-protected producers and in particular on the exportables sector.
In A More General Sense…
We could suggest that the imposition of a tariff to protect domestic producers of import substitutes acts as a tax on exportable producers in the following ways.
• To the extent that it results in higher wages across the economy and a reallocation of resources toward the protected sector it causes a decrease in the producer surplus in the exportables sector.
• To the extent that imported inputs are used in the production of the exportable goods then input prices rise without any possibility of the higher costs being passed on in the form of higher prices.
• To the extent that imports are restricted an improved trade account balance will be generated and this will put pressure on the exchange rate to appreciate. As the exchange rate appreciates the price of Australia’s exports rise and so the exportables sector becomes less competitive in world markets.
The tariff does not only act as a tax on consumers of the protected product nor does its impact fall only in the protected sector. The tariff in fact has an all pervasive impact across the economy as a whole and is in effect a tax on everyone but the protected producers.
While the protected producers are better off as instanced by the increase in producer surplus in the protected sector it should be obvious that their gains are less than society’s losses. This can be seen by noting that there are deadweight welfare losses generated in the protected sector without even taking account of the additional costs generated in the non-protected sectors.
The Specific Factors Model Revisited.
In general we can see that the impact of the tariff is to reverse the direction of change in the distribution of income in the short run generated by the movement from no trade to free trade.
We would therefore expect to see the tariff cause an ambiguous outcome for labour depending on the pattern of tastes and preferences and a redistribution towards the owners of capital that is specific to the expanding cloth sector and away from the owners of capital in the contracting wheat sector.
So the income distribution effects spread through the whole economy. This helps explain some of the hostility in the tariff debate.
The Size Of The Distortions.
We have seen that tariffs generate distortions both within the protected sector and in a broader sense across the economy. We need to comment on the size of these distortions.
Most commentators talk about the nominal tariff as an indicator of the size of the problems generated. The nominal tariff shows the percentage increase in the price of the final good generated by the tariff on that good.
This is not a good indicator of the true or real or effective rate of protection or therefore of the size of the distortions generated because of two reasons.
• It does not take account of the impact of the tariff on the value added in the domestic production process yet this is largely what motivates the production outcome.
• It does not take account of the impact of the whole structure of tariffs on production in the protected industry.
A Simple Numerical Example.
Let us, for example, assume that the free trade price of a final good, such as shirts, is Pf=$100
Further, let us assume that the free trade price of an (importable) input, such as cotton, is Pi= $80.
Now lets introduce a 10% tariff on shirts imported into Australia.
This means that the tariff inclusive price of domestic shirts can rise to $110.
The 10% tariff has increased the price of the protected product by 10%.
But is this a good indicator of the size of the distortion that will result ?
No it is not.
Note that the domestic value added, out of which net profit is generated, under conditions of free trade is $100-$80, that is the domestic producer generates a value added of $20.
With the tariff the value added rises to $110-$80, that is $30. The 10% nominal tariff has generated a 50% increase in the domestic producers value added from $20 to $30. This is a far better indicator of the effective rate of protection and therefore of the size of the distortions generated by nominal the tariff.
This is further complicated by the fact that there are often tariffs levied to protect the domestic producers of importable inputs.
If a tariff of say 5% was put in place to protect domestic cotton producers then the impact would be an increase in the price of cotton from its free trade level of $80 to the post tariff level of $84.
This means domestic cotton producers are protected but domestic shirt producers are taxed. They are taxed because they now pay more for their inputs. The effective rate of protection afforded to domestic shirt producers has therefore just decreased because of a tariff in another industry.
The effective rate of protection is now 30% because the post tariff value added is $110-$84, that is $26. When compared to the free trade value added of $20 the increase is 30%.
The effective rate of protection should therefore not just look at the impact of the tariff on the final good on the domestic value added, instead it should look at the impact of the whole tariff structure on the domestic value added.
The Effective Rate Of Protection.
We use the concept of the effective rate of protection as the best indicator of the size of the distortions generated by the imposition of a tariff. It takes account of the two problems we have just mentioned.
By definition the effective rate of protection measures the percentage increase in domestic value added of the protected good generated by the existing tariff structure.
There are many possible ways of expressing the formula that shows the relationship between the nominal tariff or nominal rate of protection (nrp) and the effective rate of protection (erp). The one we will use is the following.
The erp = tf-tisi / vi
where tf is the tariff on the final good or the nominal rate of protection, ti is the tariff on the (imported) input, si is the proportion of the imported input used in the production of the final good, and vi is the proportion of domestic value added for the final good.
Note that this formula can be extended to any number of inputs each with their own level of protection by using the appropriate weighted averages .The formula would become the following.
The erp = tf-tisi / vi.
We will stay with a simple two commodity country that has a two tier tariff structure for the purposes of our analysis.
A More Detailed Numerical Example.
Assuming a country produces two importable commodities, shirts and cotton. Assume that cotton s an input into the production of shirts. Assume also that the free trade price of shirts is $100 and the free trade price of cotton is $80. This implies an si of 0.8. It also means that the free trade domestic value added in shirt production is $20 and therefore the free trade vi is 0.2.
Note that by definition si + vi must sum to unity.
Using this information we can set up a table showing the relationship between the nrp (or tf) and the erp for different tariff structures but for a given si and vi.
nrp or tf ti erp
a 10 0 50
b 20 0 100
c 20 10 60
d 20 20 20
e 10 10 10
f 20 30 -20
a If tf > ti then erp >nrp.
b The greater the gap between tf and tI then the greater the gap between erp and nrp.
c An increase in a tariff leads to a decrease in the erp. So the erp increases as tf increases and/or as ti decreases.
d If tf = ti then erp = nrp. You cannot protect everything. True tariff reform involves closing the gaps in the tariff structure not the arbitrary reduction of individual tariffs.
e A 10% uniform tariff provides as much “protection” as a 20% uniform tariff.
f If tf<ti then erp is less than nrp and can be negative. Domestic production will be less than under free trade as a result.
b/e The average tariff rate is not necessarily a good basis for the discussion of the erp because a decrease in the average tariff can lead to an increase in the erp.
We can conclude that in any meaningful discussion of the effects of interference in the trade process we must comment on the impact of the whole tariff structure on the domestic producers value added. The erp gives a far better indication of the size of the distortions generated from the imposition of a tariff. True tariff reform comes from narrowing the gaps in the tariff structure.
The Importance Of Domestic Value Added.
We can also change the erp by changing s and v for a given tariff structure.
For example, let :
Pf = $100 Pi = $40 si = 0.4
vi = 0.6
and if we use the same tariff structures as above we can generate the following table.
nrp or tf ti erp
a 10 0 16.7
b 20 0 33.3
c 20 10 26.7
When we increase the proportion of domestic value added we see that for any tariff structure where tf > ti the erp will be decreased.
How Do We Decrease The Effective Rate Of Protection ?
• Decrease tf.
• Increase ti.
• Decrease si.
• Increase vi.
Most developed countries have a cascading tariff structure. This means that the more produced the commodity is the higher the nominal tariff tends to be. This also implies that the erp is far greater than the nrp especially on more highly processed goods.
The aim of this type of tariff structure has been to traditionally help in the development of the manufacturing sector by promoting domestic processing which will lead to higher domestic employment and greater self-sufficiency.
The Externalities Case For Tariff Intervention
An argument that is often put forward when calling for tariff intervention to aid a particular industry is based on the existence of a positive externality in the production process.
Externalities can be positive or negative and can be generated from the consumption and the production side of the economy.
The existence of an externality will lead to market failure in the sense that the actual amount exchanged in the market will be different than the efficient amount.
Markets are said to be efficient in that they lead to an efficient production outcome and an efficient consumption outcome and these outcomes coincide. The outcome is generated by the actions and reactions of buyers and sellers who are maximisers to a series of market price signals.
The efficient consumption outcome occurs where P=ME where ME is represented by the D curve.
The efficient production outcome occurs where P=MC where MC is represented by the S curve.
Note that when we discuss efficiency it is from the point of view of society. This implies that ME=MSE and MC=MSC, so efficiency occurs from society’s point of view when in consumption P=MSE and in production when P=MSC.
A problem occurs when we recall that consumers attempt to maximise private satisfaction and producers attempt to maximise private profit. This means that consumers will consume where P=MPE and producers will produce where P=MPC.
When there are no externalities there is no divergence between MSE and MPE or between MSC and MPC. This means the private consumption and production outcomes coincide with the socially efficient consumption and production outcomes.
It is in this sense that we say that markets work.
When there are externalities the private decisions will not coincide with the socially optimal decisions. There is said to be market failure.
0 Diagram A 0 Diagram B
Diagram 9.4 Positive or negative externalities in production can lead to market failure.
A Negative Externality In Production.
Refer to diagram 9.4.A.
A negative externality in production occurs when the act of production generates a cost to society. This implies that the cost schedule for society is higher or to the left of the cost schedule for the individual producer. This can be shown diagramatically as the Marginal Social Cost curve (MSC) being to the left of the Marginal Private Cost curve (MPC).
Since producers are only concerned with their private costs of production we see actual production at qA whereas efficient production is at qE.
The existence of the externality has resulted in market failure in the sense that more is being produced than what is socially desirable.
An example of a negative externality in production is the air and water pollution generated by many heavy industrial production processes. The negative spillover cost being the cost to society of living with a polluted environment.
A Positive Externality In Production.
Refer to diagram 9.4.B.
A positive externality in production occurs when the act of production generates a benefit to society. This implies that the cost schedule for society is lower or to the right of the cost schedule of the individual producer. This can be shown diagramatically as the MSC curve being to the right of the MPC curve.
Since producers are only concerned with their private costs of production we see actual production at qA whereas efficient production is at qE.
The existence of the externality has resulted in market failure in the sense that less is being produced than what is socially desirable.
An example of a positive externality in production is access roads constructed by outback miners. The positive spillover is the greater access by all of society to the outback.
Market Failure And International Trade.
In each of these instances of externalities there has been market failure in the sense that what is produced and consumed is not the socially optimal amount. This is because the market is driven by individual consumers wanting to maximise private satisfaction and individual producers wanting to maximise private profit. The spillover costs and benefits to society are ignored by the individual decision makers and therefore ignored by the market. The market outcome is not the socially optimal outcome when externalities exist.
Only one of the above four types of externality has a practical relevance to our discussion of intervention in the trade process. This is the case of the positive externality in production which results in underproduction in the industry generating the externality. If this is the importables market then there will be less actually produced domestically than what is socially desirable.
Diagram 9.5 A positive externality generated from the production of cloth, the Australian importable commodity, results in the actual level of production being less then the socially efficient level of production. Note
that this diagram shows the autarky outcome in the Australian cloth market.
The Externalities Case For Tariff Intervention.
An argument that is often put forward when calling for tariff intervention to aid a particular industry is based on the existence of an external economy in the production process of the domestically produced import substitute.
An external economy in production is where the production process is generating a benefit to society for which he or she is not being compensated. The result of this is the MSC curve will be below the MPC curve.
Since producers taking account of their private costs only will produce where P=MPC then less than the socially optimal level of output will be produced. The socially optimal level of output occurs where P=MSC.
What is produced is less than what should be produced. There is underproduction in the domestic economy.
The argument then suggests that we should impose a tariff to restrict imports and to stimulate domestic production to its socially desirable level.
Note that the argument for intervention in this context comes about because the free trade outcome is not any longer the optimal outcome.
The Production Distortion.
We can begin our analysis of this argument for tariff intervention by looking at the free trade outcome and identifying the distortion on the production side of the economy generated by the existence of the positive externality in the production process.
Diagram 9.6 Market failure due to the positive externality in production can lead to calls for tariff protection.
We focus on the Australian cloth market. Remember that Australia is a small importing country.
Note that the MSC curve is underneath the MPC curve. The vertical distance between the two curves represents the size of the positive externality in production.
The free trade price is P1.
At P1 producers will produce C1 because this is where P1=MPC which is the cost they face to produce.
At P1 consumers will consume C2 because this is where P1=MEd. Note that by using ME we are implicitly stating that there are no externalities in consumption.
At P1 we will therefore import C2 – C1 units of cloth from Taiwan.
Until now we have suggested that the free trade outcome is the optimal outcome. This is no longer true when we have a positive externality in the production process of the domestic importable commodity.
The socially optimal production point is C3 where the free trade price is equal to the MSCd which is the true cost of domestic production.
So there is underproduction with the market outcome in that we are producing at C1 and we should be producing at C3. This also means that we are importing too much.
The distortion can best be explained by comparing the cost of domestic production of the units between C1 and C3 (area FBCE) with the cost of importing the units between C1 and C3 (area ABCE). The area under the MSCd line is clearly less than the area under the MC*. This means that it is cheaper or more efficient to produce these units domestically than it is to import them. There is a waste of scarce domestic resources if we import these units instead of producing them domestically.
The Argument For Tariff Intervention.
If the objective is to increase domestic production to its socially optimal level and in the process decrease imports then it is argued by many producers that this can be achieved by putting in place a tariff equal in size to the externality.
A tariff restricts imports and increases domestic production and so helps to overcome the distortion caused by the externality. If the tariff is equal in size to the externality then we should see production at C3 where P1+t = MPCd and this should coincide with the optimal production level where P1=MSCd.
The full impact of the tariff is to increase price to P2 and so stimulate domestic production to C3.
Of course consumers also respond to the new tariff inclusive price of P2 and we see consumption as a result fall from C2 to C4.
Imports therefore decrease from C2 - C1 to C4 - C3.
Diagram 9.7 A tariff equal in size to the externality can increase domestic production to its socially optimal level.
As long as the tariff is set at the correct level the desired outcome is achieved. This means that production moves to its optimal level through the restriction of imports or that the tariff has internalised the externality.
While the outcome is successful we need to look at whether the country is in fact better off or worse off. The question really is whether or not we have an economic justification for the use of the tariff.
The Welfare Implications.
We will again use consumer and producer surplus as measures of society’s welfare. By comparing these measures before and after the imposition of the tariff we can determine whether or not the country gains or loses.
Diagram 9.8 The tariff may or may not improve society’s welfare. It generates a production gain of JEF but a by-product consumption distortion of BCD. The net outcome depends on the relative size of the gain compared to the loss.
The free trade consumer surplus is ACH.
The post tariff consumer surplus is ABK.
There has been a loss of consumer surplus equal to the difference between these two areas which is KBCH. This can be broken down into its component areas of KLEH + LBDE + BCD.
The free trade producer surplus is HJFG.
The post tariff producer surplus is KLEG.
There has been a gain of producer surplus equal to the difference between these two areas which is KLEH + JEF.
There is tariff revenue which we treat as a gain to society of LBDE.
In a net sense we gain JEF on the production side but lose BCD on the consumption side.
It is not clear whether the country is better off or not with the tariff. It depends on the relative size of the production gain and the consumption loss. The best we can claim is that the country might be better off. It depends on the elasticities of the curves involved.
So the tariff only overcomes the production distortion by introducing a by-product consumption distortion.
Is There A Better Policy ?
It has been typically the case in our analysis that the more direct the policy is in terms of the objective then the better the policy is. The tariff here is a blunt instrument in terms of overcoming the production distortion. It is a price policy and any change in price that results from the tariff will cause an undesired consumption response as well as the desired production response. This will result in a consumption distortion as well as the production gain.
A more direct policy would be a per unit production subsidy that targets directly the production distortion but does not impact on consumption. Since Australia is producing less than the optimal amount the payment of a subsidy will stimulate producers to increase output.
If the subsidy is set equal to the externality then the subsidy inclusive price received by producers when set equal to MPCd will result in production at the socially optimal level of C3. Remember that consumers will still only pay price P1 and so consumption will not be affected by this more direct policy.
Diagram 9.9 The per unit subsidy approach generates the production gain (area A) but there is no consumption loss out with the tariff.
The welfare implications of the subsidy approach mean that the same production gain is made but that there is no consumption loss and no tariff revenue. There is however the cost of the subsidy. The net impact for the country is production gain given by area Z.
The per unit production subsidy is a better, more direct and less costly policy than the tariff.
The case for tariff intervention is again not sustainable.
The Large Country Case For Tariff Intervention.
We have looked at various arguments that are commonly used to attempt to justify tariff intervention but have not found them to be economically defensible. There is always a better or more direct or less costly policy available.
There is in fact only one situation where there is an economically defensible argument for tariff intervention as a desirable first best policy. This is the large country case which is also referred to as the terms of trade argument or the optimal tariff argument.
By allowing the importing country to be large it implies that the country has market power in the imports market. The analysis of the large country is therefore similar in nature to monopoly analysis or monopsony analysis where the seller has the ability to influence the market price by its own actions.
The market outcome in these settings is achieved where MR=MC not where P=MC.
The model is based on four assumptions which are set out below.
• Australia is a large country in its imports market. This implies that it has market power in that the quantity of imports it buys influences the price it pays for its imports.
• The free trade outcome for the large country is not optimal in that while world welfare is maximised national welfare is not.
• The objective of the importing nation is to maximise national welfare irrespective of the impact it has on world welfare.
• There is no retaliation from the importing country’s trading partners when the importing country imposes a tariff and restricts its imports.
We need to construct and explain the large country diagram to identify the free trade outcome.
Note that the diagramatics are essentially the same as those we have used for the small country case. There are two differences.
The first is that we have reverted to a two diagram format by seperating the domestic market from the imports market from the domestic perspective.
The second is that because we are a large country with buying power we must face an upward sloping supply curve for imports.
Diagram 9.10 The free trade outcome in the large country case.
The upward sloping supply curve for imports is important. It is based on the recognition that because of our size in the market the quantity we purchase determines the price we pay.
The major implication of supply being positively sloped is that the Marginal cost of Imports (MC*) must lie above the Supply Curve for Imports (S*).
This can be shown with a simple set of p-q figures.
The Free Trade Outcome.
The free trade price P1 is determined by the interaction of the demand for and the supply of imports. At this price Australia produces C1, consumes C2, and imports the difference which is C’.
Note that this outcome is not optimal from the national point of view because it is not consistent with the efficiency rules. This can be seen by looking at the levels of MCd at C1, MEd at C2, and MC* at C’.
This shows that MCd=MEd<MC*.
The free trade outcome is not optimal. It does not maximise national welfare.
If the objective is to maximise national welfare then the large country can use its market power to achieve that objective.
How can it do this ?
By increasing domestic production we increase MCd.
By decreasing domestic consumption we increase MEd.
By decreasing imports we decrease MC*.
All of these help drive the MC’s and ME’s into equality and so help maximise national welfare.
Note that these changes are generated by simply imposing a tariff.
The question is how big a tariff is needed ?
Diagram 9.11 The optimal tariff is given by P2-P3.
Since Ddimp shows the price we are prepared to pay for imports, and since domestic consumers set MEd=P to determine consumption and domestic producers set MCd=P to determine domestic production, then by importing where P=MC* we will achieve the efficient outcome from the domestic perspective.
The desired price is therefore determined by the intersection of MC* and Ddimp.
At P2 we see domestic production at C3, domestic consumption at C4, and imports of C’’ which by construction equals C4-C3.
This is efficient because now MCd=MEd=MC*.
We must recognise that to achieve this outcome a tariff needs to be imposed.
To purchase C’’ units of imports the per unit price as given by the S* schedule is P3. We need a price P2 to generate the desired outcome. To push the import price from P3 to P2 we must impose a tariff equal to the difference.
Since this tariff generates the desired efficient outcome it is referred to as the optimal tariff.
While this maximises national welfare for Australia it interferes with the free trade outcome and so reduces world welfare. In fact tit must be the case that Australia’s gains are smaller than the world’s losses because world welfare has been reduced.
So Australia gains but the world is worse off.
Note the nationalistic flavour of the argument and the importance of the assumption of no retaliation.
Note also that this is the is the only economically defensible argument in favour of tariff intervention.
How Does It Work ?
The optimal tariff has two opposite effects.
The terms of trade effect means that Australia by restricting its imports will generate a lower price per unit for its remaining imports. This means that in real terms it will have to give up less in terms of exports to generate the revenue to pay for each unit of imports. This is a gain because in real terms Australia is better off.
The volume effect means that the result of the tariff is to reduce the quantity of imports and hence the volume of trade for Australia and for the world. The reduction in the volume of trade imposes a cost on Australia.
The optimal tariff maximises the difference between the gain and the loss by equating the two effects at the margin.
The Welfare Implications.
We can use consumer and producer surplus measurements to show the improvement in national welfare and to illustrate the terms of trade and volume effects.
Diagram 9.12tariff is HEDG less BCE. The net welfare gain generated by the optimal
Australia loses consumer surplus of JBCH = JBEH +BCE.
Taiwan loses producer surplus of HCDG = HEDG + ECD.
Australia gains tariff revenue of JBDG = JBEH + HEDG.
There is a deadweight loss to the world of BCD = BCE + ECD.
Australia loses BCE but gains HEDG as a transfer from Taiwan.
Note that Australia’s gains must be smaller than the world’s losses because world welfare has decreased.
So Australia gains but the world loses, Australia is in effect taking a larger share of a smaller world pie.
The TOT And Volume Effects Again…
The gain in Australia is the area HEDG. This is in effect the terms of trade effect because it comes about as the price of imports is decreased through Australia’s desire to buy fewer imports. Australia is in effect imposing part of the cost of the tariff on the rest of the world as this gain is a redistribution from Taiwan which is receiving a lower price for its exports.
This redistribution does not occur in the small country case as the small country is a price taker in its imports markets.
The loss in Australia is the area BCE. This is in effect the volume effect because it represents the distortionary effects attached to the decrease in the volume of trade.
The optimal tariff equates these at the margin and so maximises national welfare.
Any further increase in the tariff would cause the tot gain to increase by less than the volume loss.
The size of the optimal tariff depends on the elasticities of all of the relevant demand and supply schedules.
The Optimal tariff In The Small Country Case.
In the small country case the optimal tariff is zero because the S* is perfectly elastic and there is no tot gain but there is still the volume loss. The net impact of any tariff must therefore be to decrease welfare.
Diagram 9.13welfare gains. The domestic view of the net
Areas 1 and 2 represent the traditional volume distortions in the small and large country cases. Area 3 is the tot gain in the large country setting but this does not exist in the small country setting. The small country cannot impose part of the burden of the tariff on the rest of the world as the large country can. The optimal tariff in the small country is therefore a zero tariff.
The large country case is the only argument that supports interference in free trade as a first best policy. All other arguments need policy initiatives aimed at overcoming distortions that exist but that have nothing directly to do with international trade.
There are a range of other barriers besides tariffs that are becoming increasingly important as the world trade bodies continue the fight to reduce and ultimately eliminate tariffs. Many of these types of intervention are not controlled in the same way as tariff intervention is.
The most important is the quota.
A quota is a direct quantitative restriction on the amount of a good that is allowed to be imported into a country.
We can analyse the quota intervention in the same way that we have analysed tariff intervention. Our focus will be on a comparison between the two types of trade restrictions.
The most important point to begin with when comparing any forms of intervention is to demonstrate equivalence in terms of price-quantity outcomes. If equivalence is not shown then the comparison is an invalid one.
We can start with our standard tariff diagram and then set a quota equal to the posttariff import level. This must generate an identical price-quantity outcome.
Diagram 10.1 The determination of an equivalent quota for a given tariff.
Note that the quota amount in effect shifts the Sd to the right by the amount of the quota at each price. The Dd and Sd+quota then interact to determine P2 at which price we produce C3, consume C4, and import the difference which is the quota amount C4C3.
This is identical in a price-quantity sense to the tariff approach.
So we have an equivalent tariff and quota outcome.
In a general sense any type of intervention and in particular any level of quota has a tariff equivalent and so valid comparisons can be made between the various forms of intervention.
There Are Some Differences Though…
While we can demonstrate equivalence between the tariff and the quota in terms of price-quantity outcomes we can also show that the quota has greater costs than the tariff and so the tariff despite imposing costs on society is a better form of intervention than the quota.
The three major additional costs attached to the quota when compared to the tariff are as follows.
• With the quota there is no tariff revenue. What was tariff revenue is redistributed as a scarcity rent to the holder of the import licence.
• There are additional administrative costs associated with the use of the quota. These are increased when we include a recognition of the policing costs associated with the rent seeking activities that are encouraged with the quota approach.
• The quota is not as flexible as the tariff in the face of a demand expansion.
The Redistribution Cost.
Diagram 10.2 The welfare costs of the quota are greater than that of an equivalent tariff.
With the quota there is no no tariff revenue generated and so the same deadweight losses are generated but in addition there is now no tariff revenue to help offset the loss of consumer surplus.
What was tariff revenue is now a scarcity rent accruing to the import licence holders. In effect it has been transferred from society to the individual quota holders.
The scarcity rent is generated because the import licence holders can buy in the world market at P1 and sell in the domestic market at P2 and take the difference for themselves rather than the government collecting the tariff revenue and spending it equitably and efficiently on behalf of society.
So the tariff imposes a smaller cost on society than the quota.
Administrative And Rent Seeking Costs.
Quotas involve additional administrative costs than tariffs and also encourage rent seeking activities which generate policing costs that do not exist with tariffs.
Costs Due To Lack Of Flexibility.
Quotas are less flexible than tariffs in the face of an expected demand expansion.
Diagram 10.3demand expansion under a tariff. The deadweight loss triangles remain the same in size with a
With a tariff there is no change in price and the increase in demand is met by an equal increase in imports. This means there is no further distortions in consumption or production.
Diagram 10.4 With a demand expansion the welfare costs of the quota increase.
With a quota the increase in demand results in an increase in price because the quantity of imports is fixed and cannot respond. The higher price leads to an increase in the size of both the domestic production distortion and the domestic consumption distortion.
So the quota is again more costly than the tariff because of its inflexibility in the face of a demand expansion.
The quota is more costly and less efficient because it is in effect more restrictive than the equivalent tariff.
This is true for any other type of intervention.
Our focus on tariff intervention is because it is the least costly form of intervention.
Quotas are preferred by importers because of their scarcity value to the licence holder.
Voluntary Export Restraints.
Quantitative restrictions can also be “imposed” by the exporting country. This brings us to a brief discussion of Voluntary Export Restraints or Orderly Marketing Arrangements.
These are situations where the importing country negotiates with the exporting country to voluntarily reduce their exports.
Such arrangements most often apply to mature industries such as textiles, motor cars and/or steel because of the employment consequences of high import levels.
The negotiations often involve the “carrot and stick” approach.
The stick is that the negotiations often involve a threat of broad all round trade restrictions being implemented or increased unless the exporting country agrees to voluntarily limit its exports.
The carrot is that the quota revenue is in effect redistributed to the foreign producer by allowing the foreign producer to export at P2 instead of the free trade price of P1. This means that the foreign producer is “paid” to reduce exports. It also means that there is a further redistribution away from the domestic import licence holders to the foreign export producers.
The outcome of the VER/OMA is the same as for the quota in terms of rigidities but the ver is even more costly because the economic rent or scarcity value is redistributed to the foreign producer.
The Monopoly Argument For Tariff Intervention
We can now allow a monopoly producer in the domestic import competing industry and show that in fact free trade inhibits market power and so helps overcome the inefficiencies generated by the existence of the market power.
This means again that we do not need to alter our general conclusions.
Diagramatically we move from an efficient perfectly competitive market outcome to an inefficient monopoly outcome.
Diagram 10.5 The impact on prices and quantity of the monopolisation of the domestic import competing industry.
The monopoly outcome results in less being produced and a higher price being charged. This imposes welfare costs on society given by the area ABC.
If we now allow import competition we can see the impact on the domestic monopolists behaviour given that we can import all that we want at the free trade price.
The outcome therefore depends strongly on the position of the free trade price compared to the domestic price.
Remember that profit maximising output always occurs where MR=MC. All we need
to be able to do is correctly interpret what MR and MC are under different circumstances or constraints.
Diagram 10.6 The monopoly diagram.
If P*. > PM then no imports and so no constraint.
If P* < Pmin then all imports and monopoly ceases to exist.
If P*. < PM but > Ppc. then monopolist forced to lower price to be competitive and will meet all of the demand at that price because it is a profit maximiser.
If Pf.t. = Pp.c. then monopoly outcome is identical to the perfectly competitive outcome.
If Pf.t. < Pp.c. but > Pmin then the monopoly is forced to lower price and increase quantity but will only increase quantity to where P=MC, the difference between the monopoly output and total demand will be met by imports.
Note the welfare implications of allowing free trade. Our conclusions are if anything reinforced in the face of less than perfect competition.
So far our analysis has focussed on intervention to protect domestic producers of import substitutes. We could just as easily have focussed on intervention to help domestic producers of exportable goods. The analysis and the conclusions in fact are identical. Everything we have said about import intervention is equally true for export intervention.
There are many types of export intervention. Exports can be increased through direct government loans, through targeted tax relief, through subsidised export insurance, through subsidised loans to foreign purchasers, and in many other ways.
Irrespective of the form of export assistance however there will always be an export subsidy equivalent. The analysis of export intervention that we will work through is therefore an analysis of export subsidies. It is the friendliest form of export support and the conclusions we generate are generalisable to all forms of export assistance.
Note that export subsidies are essentially illegal under international trade regulations but there are many ways of disguising these types of subsidies and many countries provide some form of export assistance.
They are particularly relevant in agricultural exports. For example, the EEC has traditionally provided high price supports to their farmers to ensure that their incomes are sufficiently high to survive. This has over time led to over supply in many agricultural commodities. In turn to help sell off the excess production there has been a series of (often disguised) export subsidies paid to EEC producers. This has meant that US agricultural producers have lost third country markets and so they have through the US government retaliated with their own export subsidies and countervailing duties.
Diagram 11.1 The free trade outcome in the Australian exportables market.
We can look at the impact of the export subsidy by focussing on a small country’s exportables market before and after the export subsidy is paid.
• Construct the domestic exportables market and the export market from the Australian perspective.
• Explain the free trade outcome and show that it is efficient.
• Allow the Government to pay a per unit export subsidy and explain how this leads to an increase in the domestic price to the subsidy inclusive export price.
• Explain the post subsidy price-quantity outcomes.
• Use consumer and producer surplus to show that while the export subsidy is successful it imposes costs on society.
• Despite these costs they are commonly used because of the existence of strong agricultural lobbies and the Governments desire to protect certain industries.
• We can of course show that there is a more direct and less costly policy available in the form of a per unit production subsidy.
Diagram 11.2 The post export subsidy outcome in the Australian exportables market.
Diagram 11export subsidy is captured by triangles EBJ plus.3 The net welfare loss generated by the
Diagram 11.4 The net welfare loss from the export market perspective. The area YUV is the deadweight loss and so must be equal in size to EBJ+HKF.
Diagram 11.5 The per unit production subsidy is a more direct
and therefore less costly policy. The deadweight loss is restricted to the area HKF because there is no consumption distortion.
Diagram 11.6 The trade creating customs union.
Diagram 11.7 The trade diverting customs union.
So far trade barriers have been the same for all countries. We have used a uniform tariff in all of our analysis. We can now turn to an analysis of discriminatory intervention and use it to focus on the question of whether or not a country should seek membership of a customs union.
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