Advantages/Disadvantages of Trade, Absolute/Comparative Advantage, Tariffs & Quotas
Why Does Trade Occur?
Trade occurs between rational people because everyone benefits. Trade enables parties to obtain products they can’t produce themselves, either because they don’t possess resources or because they can’t produce efficiently. Specialization & trade allow us to produce more with the same resources & the average real standard of living is greater as a result.
Who’s better off in a trade?
Trade among individuals & businesses is almost always carried on because the parties believe they will be better off. This means both parties are better off, or the trade wouldn’t happen. Trade is not a zero-sum game, where one person must lose for another to gain. Both parties can gain.
What is Specialization?
Specialization takes place when an individual, business, or country focuses on the production of a limited number of products to make efficient use of resources.
How does specialization work?
By learning to do something well & specializing in it, most of us spend much of our time in that activity. We sell our products & use the income to buy the other products. If we specialize, we can produce more. If we can all produce more & then trade, we will be better off.
What is Absolute Advantage?
An individual (or a business or a country) has an absolute advantage in the production of a good if they can produce the good using fewer resources than another individual would.
Primary Reasons for Absolute Advantages
- Geography: Some areas are better for producing certain goods, crops, etc.
- Natural Resources: Some areas have more natural resources, or are the exclusive owners of a resource.
- Economies of Scale: Some products are made more efficiently when production facilities are larger. This is because overhead costs are spear over a larger scale of output.
- Labour Force Skills: Some areas have more productive workers or human capital that is rare in other areas.
What is Comparative Advantage?
Compare 2 individuals’ opportunity costs of producing the same good. The individual with the lowest opportunity cost (that is, the one who gives up the fewest number of other goods) has the comparative advantage in the production of that good.
The concept was first developed by David Ricardo in 1817, to explain why countries should engage in international trade even when they don’t have an absolute advantage in the production in any product. He showed that, if productivity differs between 2 countries, each country can increase its total consumption by exporting the good for which it has a comparative advantage while importing the good for which it has a comparative disadvantage.
Comparative advantage is because of opportunity costs. Countries have a comparative advantage if its opportunity cost to produce a product is less than another country’s opportunity cost to produce the same product (since that country could spend its resources better by producing another product).
Even if a country has an absolute advantage in everything, international trade is still beneficial!
Computing Opportunity Costs
Before computing opportunity cost ratios for each state, the unit labor requirements (hours needed to produce one unit) would have to be converted into labor productivities (units produced per hour).
Production Possibilities Frontier (PPF)
The PPF plots the max output of products that an economy can produce with all its resources. It can used to display the differences in opportunity costs between two economies.
The slope of the production possibilities curve represents the opportunity cost of making one additional automobile in terms of computer chips. The lower opportunity cost of making automobiles in Michigan is illustrated by the flatter slope. This would also work by flipping the axis, to show the opportunity cost of making computer chips.
PPF & Gains from Trade
Trade helps achieve a point beyond its PPF. With complete specialization, each economy can focus on the product where it has a comparative advantage, thus increasing production of both goods.
If California is able to purchase automobiles from Michigan at a price lower than California’s opportunity cost of making an automobile, and in return, supply computer chips to Michigan at a price below Michigan’s opportunity cost of making computer chips, both states gain from the exchange of products. This is shown by the outward shift (or rather pivoting) of their PPFs
The higher the difference is in their respective opportunity cost ratios & the slopes of the 2 PPFs, the greater the potential to gain from complete specialization & trade.
A Possible Exception
If the production processes are very similar, then there may be little or no gains from trade. The greater the differences in processes (and therefore costs), the greater the gains from trade.
It’s doubtful total production would be enhanced through specialization if production processes are the same, but increased competition is helpful in encouraging innovation & in holding prices down.
Objections to Free Trade
- Industries in a country who do not have a comparative advantage will suffer from competition from the same industries in another country who do have a comparative advantage.
- “Low wage countries” will create unfair competition for countries that have higher worker compensation.
- This is not always the case! It depends on labour cost per unit of production. If a Canadian worker gets paid $14 an hour, but creates 140 units of production, they’ll be more productive than a Mexican worker who gets paid $1 & creates 9 units of production.
Tariffs & Quotas - 2 Methods to Reduce Trade
What are Tariffs?
A tax on an imported good, that’s either a fixed amount or a fixed percent of the value of the product.
As the price begins to increase with a tariff, the quantity demanded decreases more with very elastic demand than if demand were less elastic. Consumers will pay a smaller portion of the tax & producers a larger portion. If demand is relatively inelastic, consumers will pay a larger portion. Elasticity of Supply also affects the portions paid by consumers & producers.
What happens when a tariff is introduced?
- Prices of imports increase.
- Quantities of imports decrease.
- Prices of domestic goods increase.
- Quantities of domestic goods increase.
- U.S. employment increases.
What are Quotas?
Legal limits on the amounts a product can be imported, which causes prices to rise.
Why Place Quotas or Tariffs?
- Protect an Industry: Protect workers in an industry.
- National Security: Protect an industry that is deemed vital for national security (since you’d want to have in-house production, in case of war with a trading partner).
- Infant Industry Argument: Allow a new industry time to grow before being subject to competition.
- However, if financial markets are sufficiently developed, this argument may not be valid as financing opportunities are available for new businesses through well-functioning banks & financial institutions.
- Political Goals: Quotas or tariffs might be placed for political purposes against another nation. Such as, punishment for an unsavoury act by another country.
- Strategic Trade: Tariffs & quotas, or simply just their threat, can get other countries to lower their trade restrictions. It can also be used to increase worker compensation & environmental regulations in another country.
What are the costs to the country?
The costs to the country are higher prices of imported & domestic goods, and less overall production (though domestic production does increase). Another cost is potential retaliation by other countries.
What is a Voluntary Export Restraint (VER)?
When a country voluntarily sets a quota for the quantity of an exported product, to a specified country.
What is Dumping?
When a country exports a product at a price that is lower in the foreign market than the price charged in the domestic market. A country would do this to purposefully hurt other nations’ industries.
However, dumping is not sustainable & any profit-oriented company could only maintain such a practice for so long.