Free Trade Theory
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Transcript of Free Trade Theory
Basics of Trade
• Defined: 2 Countries engage in economic activity
• Exports: goods/services leave country
• Imports: goods/services enter country
• Trade Surplus: Export more than import
• Trade Deficit: Import more than export
Ways to Limit Trade
• Protectionism: Gov’t policy which seeks to limit trade– Tariffs– taxes on imports– Quotas- limits on quantity imported
• Globalization: the “global” movement towards free trade – Trade without Tariffs & Quotas – Worldwide movement towards free market capitalism
2 Free Trade Terms
• Comparative Advantage = when a country can produce a good at a lower opportunity cost– They give up less!
• Absolute Advantage = when a country can produce a good more efficiently – They use fewer resources
Countries should produce (specialize) in goods where they have a comparative advantage
Trade benefits both parties (each country gets “more”)
Free Trade promotes a more “efficient” world economy
Absolute Advantage is not relevant in trade analysis
Here is my great theory!David Ricardo
Trade Theory
1000
500
1000
1000 Wheat
Coffee
Coffee
Wheat
BRAZILMEXICO
(PPF) Production Possibilities Frontier Review:
Illustrates the maximum output for a country with current resourcesAny point on the line is efficientBelow line is inefficientAbove the line is not obtainable in short run
PPF CURVE Review
1000
500
1000
1000 Wheat
Coffee Coffee
Wheat
BRAZIL MEXICO
1 Coffee = ____ Wheat 1 Coffee = _____ Wheat
1 Wheat = ____ Coffee 1 Wheat = ____ Coffee
Opportunity Cost Table
BRAZIL
MEXICO
(gain) (give-up)
1
2
1/2
1
PPF Illustrates Opportunity Cost between goods
BRAZIL MEXICO
1 Coffee = ____Wheat 1 Coffee = _____ Wheat
1 Wheat = ____ Coffee 1 Wheat = ____Coffee
1/2
2
1
1
Wheat : BRAZIL has comparative advantage---produce only WHEAT
Coffee : MEXICO has comparative advantage---produce only COFFEE
coffee
wheat
1000
500
1000
1000 Wheat
Coffee
Wheat
BRAZIL
MEXICO
Determining Comparative Advantage
BRAZIL MEXICO
1000
500
1000
1000Wheat
Coffee
Coffee
Wheat
* (500,500)* (250,500)
400 Coffee
300 Wheat
BRAZIL
0 Coffee
1,000 Wheat
1,000 Coffee
0 Wheat
MEXICO
.(700, 400)
.(300, 600)
after trade
after trade
Trade Example:
Theoretical Benefits ofFree Trade
There is not one right answer Any trade that produces a point ABOVE current PPF is efficient trade
Use Economic Logic!
Betty- types 120 w.p.m. Jim- types 60 w.p.m.
Who should do the typing? Betty or Jim?
Assumption: No errors
Betty & Jim
Betty is a lawyer & Jim is a secretary
Betty earns $140 an hour.
Jim earns $20 an hour.
Now, who should type the letter?
Jim Should!
Jim gives up less when he types!He has a comparative advantage in typing
Why: Betty types 2 times as fast as Jim Betty earn 7 times as much as Jim
Betty- types 120 w.p.m. Jim- types 60 w.p.m.
Betty has an absolute advantagein typing (she is more efficient)
Summary: Free Trade Theory
• Countries should specialize in a good where they have a comparative advantage
• Trade is mutually beneficial– End country ends up at a point above their own PPF curve
• World wide efficiency increases as a result– Produce more with same resources