Unit 4.1 and 4.2 Free Trade and Protectionism

Unit 4.1 and 4.
2 Free Trade and Protectionism
Unit 4: International Economics

Unit Overview
4.1 Reasons for trade

• Differences in factor endowments • Source of government revenue
• Variety and quality of goods • Strategic arguments
• Gains from specialization • Means to overcome a balance of payments
• Higher level extension topic disequilibrium
>>Absolute and comparative advantage (numerical • Anti-dumping
and diagrammatic representations) • Arguments against protectionism
>>opportunity cost • Inefficiency of resource allocation
>>limitations of the theory of comparative • Costs of long-run reliance on protectionist
advantage methods
• Increased prices of goods and services to
4.2 Free trade and protectionism consumers
• Definition of free trade • The effect of protected imports on export
• Types of protectionism competitiveness
• Tariffs
• Quotas
• Subsidies
Blog posts: "Free trade"
• Voluntary Export Restraints (VERs)
• Administrative obstacles Blog posts: "Protectionism"
• Health and safety standards
• Environmental standards
• Arguments for protectionism Blog posts: "International trade"
• Infant industry argument
• Efforts of a developing country to diversify
• Protection of employment Blog posts: "Barriers to trade"
www.welkerswikinomics.com 1
Unit 4.1 and 4.2 Free Trade and Protectionism
Reasons for Trade

Introduction
Abraham Lincoln was once advised to buy cheap iron rails from Britain to finish the
transcontinental railroad. He replied, "It seems to me that if we buy the rails from
England, then we've got the rails and they've got the money. But if we build the rails
here, we've got our rails and we've got our money."
To paraphrase: "If I buy meat from the butcher, then I get the meat and
he gets my money. But if I raise a cow in my backyard for three years
and slaughter it myself, then I've got the meat and I've got my money."
Why don't we keep cows in our backyard?
1. Why do nations trade?
2. What is specialization?
3. How does a nation determine what it should specialize in?
4. How do nations benefit from trade?
Blog post: "The Lord of the Ring of Free Trade"
Reasons for Trade

Introduction
"You could say that globalization, driven not by human

goodness but by the profit motive, has done far more good for
more people than all the foreign aid and soft loans provided
by well-intentioned governments and aid agencies."
-Paul Krugman
What evidence is there to support Krugman's claim?
What evidence is there to refute it?
Group A: Research and find data or an article that

supports the statement.
Group B: Research and find data or an article that

refutes the statement.
Reasons for Trade

Why do nations trade?
Why do nations trade?
Three facts help answer this question:

• Uneven distribution of natural, human and capital resources
• Efficient production requires different combinations of resources
• People may simply prefer products made in other countries due to non-price attributes
Labor-intensive goods
-Examples:
-Where?
Land-intensive goods
-Examples:
-Where?
Capital-intensive goods
-Examples
-Where?
Reasons for Trade

Comparative Advantage
Opportunity cost: the cost to society of producing a particular good is what

it could have produced with those resources instead. The opportunity cost is
what was given up in order to produce something.
Comparative advantage: When a country can produce a good or

service at a lower domestic opportunity cost than a potential
trading partner.
Absolute advantage: When a country can produce a particular good

or service more efficiently than another country. Fewer resources
are required to produce a particular good.
The principle of comparative advantage: says that total output will

be greatest when each nation produces the good for which it has the
lowest domestic opportunity cost. Nations should specialize in the
goods they produce at the lowest opportunity cost, and trade with
other nations for other goods in which they do not have a
comparative advantage.
Reasons for Trade

Define absolute advantage:
The ability of a particular person or a country to produce a

particular good with fewer resources than another person or
country
Explain the principle of comparative advantage:
Total global output will be greatest when each good is produced

by the nation that has the lowest opportunity cost domestically
for that good.
Blog posts: "Comparative advantage"
Reasons for Trade

goods
Televisions Financial services
country
China 50 40
UK 10 30
Who has the absolute advantage in television production? ________________ Financial

services? ________________.
Who has the comparative advantage in television production? __________________ Financial

services? __________________. How do you know?
Should trade take place? If so, who should produce what?
Illustrate the PPCs for the UK and China before and after trade.
Reasons for Trade

TVs PPC analysis:

PPC for China and the UK
• Clearly China has an absolute advantage in both
50 TVs and financial services.
• With its existing resources, China can produce
China more TVs and more financial services than the UK.
Should China and the UK trade? If so, who

should specialize in what?
China can either produce 50 TVs or 40
financial services. To produce one TV it
must give up 0.8 financial services. 1
10 UK financial service "costs" China 1.25 TVs
the UK can either produce 10 TVs or 30

financial services. To produce 1 TV it
30 40 must give up 3 financial services. 1
Financial services financial service only "costs" .33 TVs.
Financial services "cost" the UK less than they do China. TVs "cost" China less
than they do the UK. China should produce TVs, the UK financial services
Reasons for Trade

Practice with Comparative Advantage:
Two countries: PPC - USA PPC - Korea

39
• United States
• Korea
24
apples
apples
Two goods:
• Apples
• Cell phones
Absolute advantage?
• Apples:
13 12
cell phones cell phones
• Cell phones:
How much do apples "cost"? How much do cell phones "cost"
Comparative advantage?
• in the US? -> 1a = 1/3c • in the US? -> 1c = 3a
• Apples:
• in Korea? -> 1a = 1/2c • in Korea? -> 1c = 2a
• Cell phones:
Should the countries trade? Why or why not?
Reasons for Trade

Gains from Trade
Trading possibilities line 36 Trading possibilities line

39 USA Korea
24
apples
apples
13 19.5 12
cell phones cell phones
United States: Specialize in apples -> trade apples for cell phones with Korea. Korea should be
willing to trade 1 apple for anything up to, but not beyond, 1/2 cell phone. Before trade, 1 apple
could only be get America 1/3 cell phone. The US has gained from trade.
Korea: Specialize in cell phones -> trade cell phones for apples with the US. The US should be willing
to exchange up to three apples for one cell phone. Before trade, Korea could only get two apples for
each cell phone it gave up. Korea has gained from trade.
Reasons for Trade

Gains from Trade
PPC for Mexico and USA

30
USA Soybeans Avocados
Soybeans
20 A
Mexico Mexico 15 60
15
10 B
USA 30 90
20 30 60 90
Avocados
Suppose the US and Mexico had been producing at points A and B before trade:
-What was total output of soybeans? ______ Avocados? ______
Suppose the countries specialize and trade based on comparative advantage:
-What is the total output of soybeans? ______ Avocados? ______
-What are the "gains from trade"? ____________________________
Free Trade vs. Protectionism

Introduction
The economic argument FOR free trade, in a nutshell:
Through free trade based on the principle of comparative

advantage, the world economy can achieve a more efficient
allocation of resources and a higher level of material well-being
than it can without free trade.
Discussion Questions:
How may free trade help less economically developed countries?
How may free trade help more economically developed countries?
How could it hurt both LEDCs and MEDCs?
How could free trade lead to a loss of jobs in one country and create new jobs
at the same time (in the SAME country)?
NCEE Workbook Activity 50: Economic Efficiency and Gains from Trade

Impact of Free Trade
Questions: US Automobile Market (with trade)
• Without trade, how many cars would

P Sd
American firms produce?
• Why is Sworld horizontal?
• Why is Pw less than Pd?

Pd
• With trade, how many cars will
American firms produce?
Pw Sworld
• How many cars will be imported with
free trade?
• Who benefits from free trade? Dd
• Who is harmed by free trade? Q1 Q3 Q

Qe
Is society as a whole better or worse off with free trade? How do you know?
Give one argument for free trade and one against, referencing the diagram

Based on simple supply/demand analysis, there are winners and losers from free trade.
• Draw a supply and demand diagram P

for a good that is manufactured
domestically but also imported to
your home country.
• Show the domestic price and

quantity before trade
• Show the domestic price and

quantity after trade
• Illustrate the impact of trade on total

welfare (consumer and producer
surplus) in the economy
• Identify who benefits and who loses

from free trade in this particular
market in your country and in the
countries where the good is imported Q
from.
Based on your diagram, formulate an argument in favor of
protecting the domestic market for the good you chose.

Milk market in Switzerland

Before trade:
P Sd • Domestic producers produce Qe and sell
at a price of Pd
• Total welfare is represented by the red
shaded area.
Pd After trade:
• Market becomes perfectly competitive,
Pw Sworld which means domestic producers no longer
have ability to control price by increasing
or decreasing output. The world price is
Dd lower due to more competition from
overseas milk farmers.
Q1 Qe Q3 Q • Lower price prompts domestic milk
farmers to decrease Qs to Q1
Winners: Domestic consumers and foreign • Qd increases to Q3.
producers. Foreign household should benefit as • Since there is domestic shortage at Pw
well due to increased demand for exports, meaning imports will equal Q3-Q1.
higher AD and higher incomes. • Total welfare in this society increases
Losers: Domestic producers and their employees. from red area to the red and gray shaded
Forced to compete and sell milk at lower price. areas.
Must lower wages or lay off workers. Producer
surplus declines.

Barriers to Trade
In order to "protect" domestic industries, governments create barriers to trade:
Revenue tariff: A revenue tariff is a tax placed on a good produced

overseas and sold domestically. The purpose of such a tariff is to raise
government revenue, but the effect is to make foreign goods less
attractive to consumers.
Protective tariff: designed to shield domestic producers from foreign

competition. Put foreign producers at a competitive disadvantage in
selling in domestic markets. Should shift world supply up, increasing
price.
Import quota: Import quotas specify the maximum amount of a

commodity that may be imported from abroad into a country in any
period. The purpose is to limit the supply of imported products, to keep
domestic prices higher and domestic producers in business.

Barriers to Trade
Non-tariff barriers:
Voluntary Export Restraints (VERs): an agreement between two nations to limit trade
in particular commodities so that the producers in one nation can remain in business
providing commodities to the domestic market, rather than be forced to compete with
more efficient foreign producers.
Administrative obstacles: "the red tape" that governments may erect when free trade
agreements limit the imposition of tariffs and quotas. May include overly burdensome
quality controls, safety regulations, living-wage and other workplace standards to be
met by foreign producers. If foreign producers cannot meet these standards, their
products are forbidden from being sold domestically. May include environmental,
health and safety standards.
Subsidies: Payments from the government to producers, for example farmers, in order
to reduce the costs of production. Meant to lower the price of domestic goods to
consumers, could have the effect of keeping foreign goods out of domestic market.
Dumping: the act of a manufacturer in one country exporting a product to

another country at a price which is either below the price it charges in its
home market or is below its costs of production

Barriers to Trade
Impact of a protective tariff: P US Automobile Market
(with tariffs) Sdomestic
Before tariff:
• Domestic producers supply Q1
• Demand is Q4
• country imports Q4-Q1
After tariff:
• World supply shifts up as foreigner
Gov't rev.
producers face higher cost to sell their
cars Pw+t Sworld + tariff
• Pw increases to Pw+t
• Domestic producers supply Q2 Pw Sworld
• country imports Q3 - Q2
• Blue area represents CS that is DWL
transferred to PS due to higher price of
cars Ddomestic
• Gov't tariff revenue equal to yellow
area. 0 Q
Q1 Q2 Q4
• DWL equal to black triangles Q3
Total world efficiency in automobile production declines by an amount

represented by the black triangles.
Americans now pay more for their cars and have fewer to choose from.

Quick Quiz
Explain two benefits (gains) which might arise from international trade.
(Total 10 marks)
Students might explain the benefits in terms of any two of the following:
• a more efficient allocation of resources
• the principle of absolute and comparative advantage
• enlargement of markets
• greater employment prospects
• possibility of economies of scale
• international competition and the overcoming of abuse of monopoly power
• greater choice for consumers.
• Some answers might be framed entirely in terms of comparative advantage and if this is done fully and well and at least two
distinct points are made, it should be possible to earn full marks.
Using an appropriate diagram, explain who gains and who loses from the
introduction of a tariff. (Total 10 marks)
• definition of a tariff
• diagrammatic representation of a tariff
• illustration of impact of tariff on the government and analysis
• illustration of impact of tariff on the consumer and analysis
• illustration of impact of tariff on the producer and analysis

Barriers to Trade
Impact of a protective subsidy:
P US Automobile Market
A subsidy to domestic Sdomestic
(with subsidy)
producer is a payment to from
the gov't to the firm per unit of Sw/ subsidy
output.
Before subsidy:
• domestic producers supplied Q1
• Demand was Q3 DWL
• country imported Q3 - Q1.
Ps
After subsidy: Subsidy
• Subsidy increases the price Pw Sworld
producers receive.
• Increases producer surplus by
blue area. Ddomestic
• costs taxpayers amount equal
to blue + black area.
Q2 Q
• Domestic output increases to Q20 Q1 Q3
• country imports only Q3 - Q2.
Black triangle represents DWL to society. Cost of subsidy exceeds benefits to society, therefore
there is a total loss of welfare.
Consumers will still pay Pw, so there's no gain nor loss of consumer surplus. But since their tax
dollars are being used to subsidize inefficient domestic producers, society as a whole is worse
off after the subsidy.

Barriers to Trade
Impact of a protective quota: US Automobile Market (with quota)
P
Sdomestic
Before the quota:
• Domestic producers supplied Q1 Sw/ quota
• Demand was Q4
• country imported Q4 - Q1
Gov't sets a quota of Qu foreign

autos
• At Pw, domestic output is still Q1, but P
imports are reduced to Q1-Q2 q
DWL
• At Pw there is excess demand of Q4-Q2. P
• The shortage leads to an increase in w Sworld
the price to Pq, Qu
• higher price attracts new domestic
producers into the market, shifting Sd
Ddomestic
out to Sw/quota.
• Domestic producers now produce 0- 0 Q1 Q2 Q3 Q4 Q
Q1 and Q2-Q3.
Consumers buy fewer cars and pay a higher price. Purple and pink areas used to be
CS and are now PS. Blue are is now PS for foreign producers who are getting a
higher price for their cars.
Gray area is DWL since it used to be CS but is now lost welfare. This triangle
represents a net loss of world efficiency resulting from the restriction of free trade.

Barriers to Trade
US Automobile Market (with tariffs)

P Sdomestic
Gov't rev.
Pw+t Sworld + tariff
Pw Sworld
DWL
Ddomestic
0 Q1 Q2 Q3 Q4 Q

Barriers to Trade
P US Automobile Market (with subsidy)

Sdomestic
Sw/ subsidy
DWL
Ps
Sworld
Ddomestic
0 Q1 Q2 Q3 Q

Barriers to Trade
US Automobile Market (with quota)

P
Sdomestic
Sw/ quota
Pq
DWL
Pw Sworld
Qu
Ddomestic
0 Q1 Q2 Q3 Q4 Q

Barriers to Trade
Evaluating the effects of trade barriers:
Direct effects Indirect effects

What direct effect will a tariff that raises the price What indirect effects might the introduction
of a commodity in the domestic market have on: of a tariff have on:
domestic consumers? domestic consumers?
domestic producers of the commodity?

domestic producers?
domestic producers of other products?
foreign producers? domestic incomes?
foreign incomes?
domestic government?
Global allocative efficiency?
Is a tariff a regressive, progressive, or proportional tax? Who is affected more, rich or poor?
Practice Barriers to Trade: NCEE Workbook Activity 51

Barriers to Trade
Arguments for protectionism: Despite the apparent economic benefits free trade brings,
there are still many who oppose it on several grounds.
Protecting domestic employment:
Protecting the economy from low-cost labor:
Protecting an infant industry:
To avoid the risks of over-specialization:
Strategic reasons:
Protection against “dumping”:
To protect product standards:
To raise government revenue:
To correct a balance of payments deficit:
Which of these arguments for protectionism do you feel are most valid?
Discuss with a partner...

Barriers to Trade
Arguments against protectionism: Most economists today acknowledge the value

of free trade. Their opposition to protectionism rests on the following grounds:
Protectionism leads to...
Higher prices for producers and consumers:
Less choice for consumers:
Less competition, less efficiency:
Distorts comparative advantage, less efficient allocation of resources, total world

output declines:
May hinder economic growth:
Which of these arguments against protectionism do you feel are most valid?
Discuss with a partner...

Barriers to Trade
Points to consider in evaluation of protectionism:
1. The European Union has prospered as trade barriers have been eliminated.
2. The world economy has grown under the trend toward more tariff reduction since the mid-1930s.
3. High tariffs were a factor in causing the Great Depression.
4. Nations with high protectionist policies have slower growth than those with no barriers.
Find an article from the current press relating to a free trade agreement (FTA). Read
and discuss with your partners at your table. On a poster, identify the following points:
• What are the pros and cons of the Free Trade Agreement discussed in your article?
• What are the alleged benefits of the agreement being discussed?
• Who are the opponents of free trade and what are their arguments?
• Who are the supporters of free trade and what are their arguments?
Possible articles:
Korea, EU Look Forward to Progress in Free Trade Talks
Bush: New Free Trade Deals Will Strengthen U.S. Economy, Create Jobs
India-Sri Lanka Free Trade Agreement (FTA): Success and the road ahead
Rice Pushes for Free Trade Pacts Smart trade, the Clinton way
Peru's president embraces free trade

Barriers to Trade
Conflicting views
Follow the links below for some ideas from the opposing sides:
Evaluate the video or article:

1) what views on trade are expressed in the video?
2) Are there biases expressed by the people in the video? If so, what are they?
3) Evaluate the arguments for or against free trade made in the video.
Make Trade Fair - by Oxfam Lou Dobbs on the dangers of trade

http://www.youtube.com/watch?v=9mgPEP8HAss http://www.youtube.com/watch?v=0MKIBMCVRwQ
Joseph Stiglitz on globalization More Lou Dobbs with guest David Sirota
http://www.youtube.com/watch?v=pdGC5Bemjxo
http://www.youtube.com/watch?v=wXxIqklh7P0&feature=related
Ambassador to Columbia on the Benefits

Columbian FTA, why it's good for America
of Free Trade
http://www.youtube.com/watch?v=N6gJBBTOIoA
http://www.youtube.com/watch?v=ffu4CJ8iOdg
Kenyans want trade not aid

Obama vs. McCain on Free Trade - 3rd Debate
http://www.youtube.com/watch?v=mt_ASiufQtY
http://www.youtube.com/watch?v=ThD6n_ImKKI

Barriers to Trade
Quick Quiz: Who benefits from protectionism? Who is hurt? Why

do most economists agree that free trade is beneficial overall?
Protectionism…
• Benefits: Domestic producers may benefit b/c they receive a higher price for
their output. The federal government may gain through revenue from tariffs.
• Hurts: Consumers are harmed b/c they pay higher prices for goods
produced by the protected industry. Foreign producers are hurt b/c they are
not able to sell their as much of their output as they would be able to
otherwise, so their profits are reduced.
• Economists oppose most protectionism because: In most cases, the costs

of protectionism exceed the benefits. Consumers are hurt by the higher prices
they pay, while producers often benefit less. Also, industry employs large
amounts of economic resources in “rent-seeking” as they lobby congress to
erect barriers to trade. In most cases, protectionism results in deadweight loss
for society, meaning economic inefficiency.
Blog post: "Excuse me China, could you lend us another billion?"
Attachments
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Unit 4.1 and 4.

Unit 4: International Economics

4.1 Reasons for trade

Reasons for Trade

Why don't we keep cows in our backyard?

1. Why do nations trade?

3. How does a nation determine what it should specialize in?

4. How do nations benefit from trade?

Blog post: "The Lord of the Ring of Free Trade"

Reasons for Trade

"You could say that globalization, driven not by human

What evidence is there to support Krugman's claim?

What evidence is there to refute it?

Group A: Research and find data or an article that

Group B: Research and find data or an article that

Reasons for Trade

Why do nations trade?

Three facts help answer this question:

Reasons for Trade

Opportunity cost: the cost to society of producing a particular good is what

Comparative advantage: When a country can produce a good or

Absolute advantage: When a country can produce a particular good

The principle of comparative advantage: says that total output will

Reasons for Trade

Define absolute advantage:

The ability of a particular person or a country to produce a

Explain the principle of comparative advantage:

Total global output will be greatest when each good is produced

Blog posts: "Comparative advantage"

Reasons for Trade

Who has the absolute advantage in television production? ________________ Financial

Who has the comparative advantage in television production? __________________ Financial

Should trade take place? If so, who should produce what?

Reasons for Trade

TVs PPC analysis:

Should China and the UK trade? If so, who

the UK can either produce 10 TVs or 30

Reasons for Trade

Two countries: PPC - USA PPC - Korea

Reasons for Trade

Trading possibilities line 36 Trading possibilities line

Reasons for Trade

PPC for Mexico and USA

Free Trade vs. Protectionism

The economic argument FOR free trade, in a nutshell:

Through free trade based on the principle of comparative

How may free trade help less economically developed countries?

How may free trade help more economically developed countries?

How could it hurt both LEDCs and MEDCs?

Free Trade vs. Protectionism

Questions: US Automobile Market (with trade)

• Without trade, how many cars would

• Why is Sworld horizontal?

• Why is Pw less than Pd?

• Who benefits from free trade? Dd

• Who is harmed by free trade? Q1 Q3 Q

Free Trade vs. Protectionism

• Draw a supply and demand diagram P

• Show the domestic price and

• Show the domestic price and

• Illustrate the impact of trade on total

• Identify who benefits and who loses

Free Trade vs. Protectionism

Milk market in Switzerland