1. International Trade
Countries can consume beyond their own PPF if they trade each specialise in goods with comparative advantage
The rate of exchange will be somewhere between their opportunity cost ratios
The rate of exchange is measured by the “terms of trade” – an index of export prices divided by index of import prices (the greater a quantity of imports a country can acquire for a given quantity of exports, the higher the “terms of trade”)

2. The Importance of International Trade
Bananas
Bananas B C C A A B
Wine
Wine EU
USA
Without trade, each produces at A
With complete specialisation, each produces at B
Trade occurs at an exchange rate somewhere between opportunity costs (same slope for both countries) therefore both can consume greater quantity of Bananas and Wine

3. Advantages and disadvantages of free trade
Specialisation leading to increased output
Trade allows economies of scale (larger market to sell to)
Lower price and increased choice
Competition and innovation
Risk – interdependence, over- reliance on trade, loss of control
Unemployment (perhaps)
Income inequality
Environmental impact
Culture

4. Welfare Gain From Trade
S domestic
P domestic A B C
S world
P world
D domestic
Q S domestic
Q D domestic
Imports
Consumer surplus gain = A + B + C
Producer surplus loss = A
Total welfare gain = B + C

5. Trade Protection Options
Tariffs: taxes on imports
Quotas: quantity restrictions on imports
Subsidies: given to domestic firms to help them compete in foreign markets
Regulations: can make it very difficult or expensive for foreign products to comply

6. Tariffs – A Loss of Welfare
S domestic
P tariff A B C D
S world
P world
D domestic
Q S1 free trade
Q S2 with tariff
Q D2 with tariff
Q D1 free trade
Lower Imports
Consumer surplus reduced by A + B + C + D
Producer surplus increased by A (domestic producers expand production at ↑ price)
Gov’t tax revenue = C
Total loss of welfare = B + D

7. Welfare loss from quota
Quota amount decided, added to domestic production
Loss in consumer surplus is A+B+C+D
SD1
Price
Gain in producer surplus is A
PW +q
Who receives C? A B C D PW SW
Generally importers, so welfare loss is B+C+D D
If the government sold licences to import, welfare loss is between B+D and B+C+D
So tariffs are better than quotas
QS1
QS2
QD2
QD1
Quantity

8. Welfare loss from subsidy
Original producer surplus is A
SD1
Price
New producer surplus is A+B+C+D
SD2
Gain in producer surplus is B+C+D PW SW S A C
Subsidy costs taxpayers A+B+C+E B E D
PW - S
So loss from subsidy is A+B+C+E minus B+C+D
Which is A+E-D D
QS1
QS2
QD1
Quantity
Since A is the same as D the loss is E

9. Why have trade restrictions?
If countries specialise according to comparative advantage there are major gains from trading
Tariffs, quotas and other restrictions lead to welfare loss, so why do some countries have protectionist policies?

10. OUT

11. Reasons for Protection
Reasons might generally be counted as excuses, but include:
The infant industry argument. This is the key one
Dumping
Job protection
Strategic industries

12. The Infant Industry Argument
It states that countries, especially developing countries, have a potential comparative advantage in manufacturing and they can realise that potential through an initial period of protection
Without protection, domestic firms cannot compete at the world price
It is therefore argued that it is a good idea to use tariffs, import quotas or subsidies as temporary measures to get industrialisation started
Once the industry has developed – eg has learnt how to produce and has economies of scale – then it can compete with large international firms, and the protection can be removed

13. Problems Lots of problems
Who decides which industries to protect, and how?
Why can’t the private sector invest in the industry knowing it will be profitable in the future?
It may be wasteful to support industries now that will have a comparative advantage in the future
With protection, infant industries may never “grow up” or become competitive. In other words does protection actually lead to developing comparative advantage?
Do governments withdraw protection, or does it become semi-permanent?

14. Extension: market failure and infant industry
Two principal arguments for why protection is needed because market failures prevent infant industries from becoming competitive:
Imperfect (financial) capital markets
Because of poorly working financial laws and markets, new industries are not allowed to borrow as much as they need, which results in restricted growth.
If creating better functioning laws and markets is not feasible, then high tariffs would be a second-best policy to increase profits for new industries, leading to more rapid growth.

15. Extension: market failure and infant industry
The problem of appropriability
Firms may not be able to privately appropriate (keep the profits) the benefits of their investment in new industries. Most obvious in technology, when the benefits of a firm’s investment in technology become available to the rest of the economy.
The knowledge created when starting an industry may be not appropriable because of a lack of property rights.
If establishing a system of property rights is not feasible, then high tariffs would be a second-best policy to encourage growth in new industries.

16. Theoretical Costs and Benefits of Infant Industry Protection (with tariffs)
Today n
Price
MC = Domestic Supply
Pw + t Pw
Domestic Demand
QS1
QS2
QD2
QD1
Quantity

17. Theoretical Costs and Benefits of Infant Industry Protection (with tariffs)
Today
Revenue from tariff C n
Plus increase in producer surplus
Price A
MC = Domestic Supply
Pw + t A C Pw
Domestic Demand
QS1
QS2
QD2
QD1
Quantity

18. Theoretical Costs and Benefits of Infant Industry Protection (with tariffs)
Today
Minus loss in consumer surplus
Quantity
QD1
Future
Domestic
Demand E
Is E greater than
B + D?
A + B + C + D n
Price
Equals B + D
MC = Domestic Supply
MCI= SI
Pw + t A C B D Pw
Domestic Demand
QS1
QS2
QD2
QD1
Quantity
QS3

19. Empirical Evidence Yes, welfare increased due to intervention
Various attempts to measure effectiveness. For example, input per unit of output must fall more rapidly in more protected industries if there is to be any rational for infant industry protection.
Most quoted case is Krueger (1982) finds no such tendency over the period covered analysing protection in Turkish industries
Industry-specific case studies
Yes, welfare increased due to intervention
Aircraft in Europe (Baldwin and Krugman (1989))
Steel rail industry in the USA (Head (1994))
Production of electricity from wind power (Hansen et al (2003))
No, welfare fell as a consequence of intervention
Semi-conductors in Japan (Baldwin and Krugman (1986))
Tinplate in the United States ( Irwin (2000))
Computers in Brazil (Luzio and Greenstein (1995))

20. Other reasons - dumping
From the World Trade Organisation (WTO)
Article VI of the GATT provides for the right of contracting parties to apply anti-dumping measures, i.e. measures against imports of a product at an export price below its “normal value” (usually the price of the product in the domestic market of the exporting country) if such dumped imports cause injury to a domestic industry in the territory of the importing contracting party.
In other words countries can protect domestic industries if they are damaged by the sale of a product by a foreign firm at a price well below the price in the firm’s own domestic market
Must be a much lower price and must be shown to damage domestic firms for protection to be permitted
Sometimes written that dumping is when firms sell below cost. This may be a reasonable assumption since firms should not be selling below cost in their own market, but the test is based on price
Dumping may happen when:
The goods have already been produced and the firm cannot sell them in its own market (or others)
A firm may have excess capacity and will produce and sell as long as the price is above variable cost
A large foreign firm is trying to predatory price – force the domestic firm out of the industry (very naughty)

21. Other reasons Protecting jobs Protecting strategic industries
When cheap imports leads to structural unemployment
This is a poor argument. This negates the advantage of specialisation from comparative advantage and there is a welfare loss (as seen before). The exporting country might retaliate
Protecting strategic industries
Particularly in an interdependent world, there may be industries which a country views must be protected, particularly defence