Free Trade Theory

Why Nations Trade

Why Trade?

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

Specialization works!

Any illegal activity you can think of…

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Idaho

Nevada

Texas

Florida

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

Free Trade Worksheet

• Handout #1

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

BRAZIL MEXICO

1000

500

1000

1000Wheat

Coffee

Coffee

Wheat

* (500,500)* (250,500).(700, 400)

.(300, 600)

after trade

after trade

Theoretical Benefits ofFree Trade