International Trade and Policies

Production Possibility Curve (PPC)

• Concave down curve for a many person economy
• Gradient of the curve represents opportunity cost
• Gradient is increasingly negative which represents: law of increasing opportunity cost

Consumption Possibilities Curve (CPC)

The CPC is a graph that shows the maximum amount of one good that can be consumed for every possible level of consumption of the other good, i.e. all the combinations of two goods that consumed. The relationship between PPC and CPC depends on international trade:

• Closed economy: one that does not trade externally, CPC can only equal to PPC
• Open economy: one that does trade externally, CPC can be greater than PPC through trade

Important Features

• Gradient of the CPC represents the relative price of the two goods on the world
• Point of intersection: where the OC of the production of a good is equal to its price on the world PPC will ALWAYS intersect CPC at some point

The economy should produce at point C because:

• If it produced at H, opportunity cost of producing a computer is greater than that of buying one on world market, so it should reduce its domestic production and import more instead
• If it produced at I, opportunity cost of producing a computer is less than that of buying one on world market, so it should reduce its imports and produce more domestically instead

Demand and Supply Perspective on Trade

In a closed economy, the equilibrium price and quantity is determined by the intersection of the domestic demand and supply curve.

In an open economy, the domestic price of a good must equal its world price, the price at which a good is traded on the international market. If this price is:

• Lower than the equilibrium price, then the world has a comparative disadvantage. Thus, demand is greater than supply and this difference must be imported
• Greater than equilibrium price, then the domestic economy has a comparative advantage.

          Thus, supply is greater than demand and this difference must be exported

In general:

• If the price of a good in a closed economy is greater than the world price, the economy becomes a net importer of that good
• If the price of a good in a closed economy is less than the world price, the economy becomes a net exporter of that good

Winners and Losers from Trade

Although international free trade benefits the economy as a whole, some groups within the economy are better off while others are worse off.

1. Consumers benefit from lower prices from imports so they can consume Therefore, consumer surplus increases by the sum of the purple and green area. Domestic producers lose because they now have to sell at lower prices, so producer surplus decreases by the purple area.
2. Consumers lose because they now have to pay higher prices and consume less, so consumer surplus decreases by the purple area. Domestic producers benefit from being able to sell at higher prices as economy opens up to international trade at world prices. Thus, producer surplus increases by the sum of the purple and green area

In general:

• When a good is imported, domestic consumers benefit and producers suffer
• When a good is exported, domestic consumers suffer and producers benefit

Protectionist Policies

Protectionism is the use of policies intended to protect domestic industries from competition, since producers are hurt when imported goods are cheaper than domestically produced goods. Free trade allows countries to specialise in the production of those in which they have the greatest comparative advantage. This makes the economic pie as big as possible whereas protectionism prevents this and thus protectionist policies are inefficient. However, producers are better organised politically so they are often successful in lobbying for trade barriers.

Instead, the gains from free trade should be used to compensate the loss producers suffer, or at least reduce its impact, such as retraining workers for other sectors.

Ø  Import Tariff

Tariff is a tax imposed on an imported good which essentially raises the world price of that good, allowing domestic producers to raise their prices of that good to match the new world price while consumers must pay more. This decreases

demand and increases supply, so the difference between demand and supply, i.e. the amount imported, decreases.

The clear winners are the domestic producers, who can now charge more for their products. Government also win because they collect revenue from tariffs, which is equal to the bright blue area in middle.

However, total economic surplus decreases, so there is deadweight loss

Deadweight Loss:

• Consumption Loss (green area): some people can't afford anymore, so less is bought
• Production Loss (purple area): loss of efficiency, as resources taken from other goods, where they are more efficiently produced

Ø  Import Quota

Quota is a legal limit on the quantity of a good that can be imported. At world price, the quantity that needs to be imported is qD - qS but by limiting it with a quota, producers now need to supply more to cover the demand. For producers to do that, price has to rise as an incentive. Thus it can be thought of a shift in supply to match the new price as well.

The market effect of quota and tariff is exactly the same, if the quota is set to permit the same level of import as the tariff. However, with a quota, the government collects no revenue!

 With quotas, the revenue that would’ve gone to the government with a tariff instead goes to firms or individuals that have the right to import the good. E.g. importers of computers can purchase them at world price on international market, and then sell them at a higher price in domestic market to pocket the difference.