Book 13D - Free trade

Describe reasons for horizontal intra-trade

• Trade in different varieties of the same end-product of the same industry

Reasons: 

1. Differences in products and taste 

2. EOS 

• Each country should specialise to take advantage of EOS and cater to minority tastes in other country by trading 

3. Narrowing technological gaps 

• Countries start exporting similar products 

1. Seasonality (Eg. Fruits)

Describe vertical intra-trade

• Trade in components and finished products belonging to the same industry 

• Reasons: Theory of CA 

• Eg. Labour-intensive component produced in labour-abundant countries while skill-intensive component produced in capital-intensive countries

Draw free trade

Describe free trade

• Without international trade, a Country will only be able to depend on domestic production for consumption

• The quantity transacted of (steel) is Q1 and the price is P1

• Assuming that USA is a net importer, the world supply curve is drawn below the domestic price as other countries have comparative advantage and are able to produce (steel) at a lower cost and thus sell it at a lower price

• The world supply is illustrated as a horizontal line, Sworld at Pw

• It is perfectly price elastic because world economy is assumed to have almost infinite spare capacity to meet USA’s demand for (steel)

• With free trade, consumers can now purchase the (steel) at Pw instead of P1

• The lower prices will lead to a rise in quantity demanded from Q1 to Qd1.

• However, if consumers are only willing to pay Pw, domestic producers will only be willing to produce up till Qs1 instead of Q1

• This results in the domestic shortage of Qd1-Qs1 at Pw which is addressed by domestic consumers importing (steel) from the world market

• Hence, the quantity transacted in the market is Qd1 where Qd1 is made up of both domestic production Qs1 and domestic imports (Qd1-Qs1) 

Describe costs of free trade

Cost: Decrease PS and higher UN

With a lower price, there is a decrease in production of domestically produced goods from Q1 to Qs1 -> fall in derived demand for FOP such as labour -> higher level of unemployment Assuming that the minimum price at which producers are willing and able to produce the good remains constant, since they now receive a lower price for the goods, the difference between the two is now smaller for the new quantities produced domestically Since the gain in consumer surplus P1BCPw as a result of the lower prices and higher quantity demanded is greater than the loss in producer surplus, P1BEPw -> overall increase in societal welfare of BCE as a result of free trade

Define CA

• (Def.): Mutually beneficial trade between countries is possible whenever one country has a comparative advantage in producing an item over another country -> it can produce a good at lower opportunity cost in terms of other goods sacrificed

Qns: Explain how benefits to the economy can arise from specialisation and exchange (trade) = THEORY OF CA 

Qns: Explain why benefits from specialisation not always achieved = LIMITATIONS of CA

State assumptions of CA

1. Perfect competition 

2. Perfect mobility of resources within the country

3. Imperfect mobility of resources between countries

4. Constant opportunity costs of production

5. No transport costs

6. No trade restrictions