econ chap 2 - Free trade and protection

Why do countries specialise and trade?

To raise living standards — countries focus on what they produce most efficiently and trade for what they produce less efficiently.

What is comparative advantage and why is it important?

Producing a good/service at a lower opportunity cost. It’s the basis of international trade, because trade is driven by relative costs, not absolute costs.

What is absolute advantage?

When a country can produce a greater quantity of a good with the same resources, or the same quantity with fewer resources (lower absolute cost per unit).

What happens when countries specialise based on absolute advantage?

World output increases, both countries can consume more than before trade, improving living standards.

How is the rate of exchange (terms of trade) determined in absolute advantage?

It lies between the countries’ opportunity cost ratios for the goods being traded.

What if one country has an absolute advantage in both goods?

Gains from trade are still possible — this leads to the concept of comparative advantage.

Comparative advantage (definition)?

Producing a good at a lower opportunity cost than another country; it’s the basis of trade (not absolute advantage).

When one country has absolute advantage in both goods, who has comparative advantage?

The country with the greatest absolute edge has CA in that good; the other country has CA where its absolute disadvantage is smallest.

What do countries gain by specialising on comparative advantage?

Higher total output and the ability to consume beyond their PPFs after trade = higher living standards.

Using inputs (e.g., labour hours), how do you find CA?

Compute opportunity cost with inputs:

• OC of Good A = (hours for A) ÷ (hours for B)

• Lowest OC = comparative advantage.

Sources of comparative advantage?

Factor endowments (natural resources, labour, capital), quality/skills of labour, technology/productivity, and climate. These can change over time.

Policy takeaway of CA

Free trade that aligns with comparative advantage raises national income and living standards in the long run.

How does comparative advantage link to trade flows?

A country exports goods where it has a comparative advantage (lower opportunity cost) and imports goods where it has a comparative disadvantage.

How do prices show comparative advantage?

If the domestic price < world price, the country is relatively efficient, it has comparative advantage, it will export.
If the domestic price > world price, it is less efficient, it has comparative disadvantage, it will import.

What happens in the case of exports?

Producers gain (sell more at a higher price), consumers lose (pay more, buy less).

Net effect: producer gains > consumer losses, welfare rises.

What happens in the case of imports?

Consumers gain (buy more at lower price), producers lose (sell less at lower price).
Net effect: consumer gains > producer losses, welfare rises.

What does consumer and producer surplus analysis show for trade?

In both exports and imports, the net gain (extra surplus area) proves that trade increases overall economic welfare.

What is protection in trade?

Protection is government action that restricts international trade by giving domestic producers an artificial advantage over foreign producers.

What are the main types of protection?

• Tariffs – taxes on imports.

• Subsidies – government payments to domestic producers.

• Quotas – quantitative limits on imports.

What is a tariff?

A tax on imports designed to raise their price and give domestic producers a price advantage.

Who gains and who loses from tariffs?

• Domestic producers: gain (sell more at higher price).

• Government: gains tariff revenue.

• Consumers: lose (pay higher prices, buy less).

What is the welfare effect of a tariff?

Creates a deadweight loss (lost consumer surplus not transferred to others). Tariffs distort resource allocation and reduce total surplus.

Why can tariffs reduce exports as well as imports?

By raising input costs for other industries, tariffs reduce their international competitiveness → exports may fall.

What is a subsidy?

A government payment to domestic producers to lower costs and increase output.

Who gains and who loses from subsidies?

• Domestic producers: gain (produce more, compete with imports).

• Consumers: appear unaffected (same price/quantity) but actually lose indirectly (higher taxes/opportunity cost of govt spending).

• Government/taxpayers: bear the cost.

What is the welfare effect of a subsidy?

Creates a deadweight loss because the cost of the subsidy exceeds the producer gain. Distorts resource allocation and acts as a hidden “invisible tax”

What is a quota?

A limit on the quantity of a good that can be imported.

Who gains and who loses from quotas?

• Domestic producers: gain (more market share).

• Consumers: lose (higher prices, less choice).

• Government: does not raise revenue (unless quotas are auctioned).

What is the welfare effect of quotas?

Like tariffs, quotas create a deadweight loss — reduced consumer surplus and distorted resource allocation.

Why do governments use protection despite free trade gains?

Protection benefits specific groups (producers, workers) while the costs are spread across consumers and taxpayers

Main arguments for protection:

• Anti-dumping

• Infant industry

• Diversification

• National security

• Increased employment

• Cheap foreign labour

• Favourable balance of trade

What is the anti-dumping argument for protection?

Dumping = selling exports at lower prices overseas than at home.
Argued to be “unfair competition” aimed at driving out domestic producers. Temporary protection may deter it, but hard to prove if it’s dumping or just efficiency.

What is the infant industry argument for protection?

Infant industries are new industries lacking experience and scale.
Protection is justified short-term so they can grow, gain economies of scale, and develop comparative advantage. Weakness: often becomes permanent and discourages efficiency (“old age pension”).

What is the diversification argument for protection?

Diversification spreads production across multiple industries. 

Protecting a wider base prevents dependence on a few sectors (e.g., minerals). But economies naturally evolve, and governments are poor at “picking winners.”

What is the national security argument for protection?

Protection ensures supply of vital industries in emergencies (e.g., defence).
More relevant in wartime. Weakness: every industry could claim to be “vital”; trade generally promotes cooperation.

What is the increased employment argument for protection?

Protection creates jobs in the protected industry.
While true for that industry, jobs are lost elsewhere as input costs rise and consumers have less to spend. Net effect on employment is small or negative.

What is the cheap foreign labour argument for protection?

Domestic workers need protection from countries with lower wages.
Wages reflect productivity; low-wage nations have CA in labour-intensive goods. Free trade benefits all by letting each country specialise.

What is the favourable balance of trade argument for protection?

Restrict imports to reduce a trade deficit.
Misleading because imports are not “bad” and exports are not “good.” Cutting imports also cuts exports (higher costs, retaliation). Both bring gains.

What is trade liberalisation?

The process of reducing or removing trade barriers (tariffs, quotas, subsidies) between countries. Opposite of protection.

What role does the WTO play in trade liberalisation?

Promotes multilateralism, persuades countries to lower barriers together; discourages unfair practices (dumping, export subsidies); ensures trade flows smoothly.

What are the key benefits of trade liberalisation?

• Higher GDP and economic growth.

• Higher real incomes and wages.

• Lower prices and input costs.

• Greater consumer choice and variety.

• Stronger export industries and more efficient resource use.

• Increased job opportunities in efficient industries.

What short-term costs can occur when protection is reduced?

Structural unemployment in protected industries.
But over time, workers/resources shift into efficient export industries → net employment increases.