Free Trade Theory

1. Free Trade Theory Why Nations Trade

2. Why Trade?

3. Basics of Trade • Defined: 2 Countries engage in economic activity • Exports: goods/services leave country • Imports: goods/services enter country • Trade Surplus: Exportmore than import • Trade Deficit: Import more than export

4. 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

5. 2 Free Trade Terms • Comparative Advantage = when a country can produce a good at a loweropportunity cost • They give up less! • Absolute Advantage = when a country can produce a good more efficiently • They use fewer resources

6. David Ricardo Trade Theory Here is my great theory! • 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

7. Idaho Florida Texas Nevada Specialization works! + Any illegal activity you can think of…

8. PPF CURVE Review MEXICO BRAZIL Coffee 1000 1000 Coffee 500 Wheat 1000 Wheat (PPF) Production Possibilities Frontier Review: Illustrates the maximum outputfor a country with current resources Any point on the line is efficient Below line is inefficient Above the line is not obtainable in short run

9. Free Trade Worksheet • Handout #1

10. PPF Illustrates Opportunity Cost between goods Coffee Coffee BRAZIL 1000 1000 MEXICO 1000 500 Wheat Wheat Opportunity Cost Table BRAZIL MEXICO 1 Coffee = ____ Wheat 1 Coffee = _____ Wheat 1 Wheat = ____ Coffee 1 Wheat = ____ Coffee (gain) (give-up) 1/2 1 1 2

11. Determining Comparative Advantage BRAZIL MEXICO 1 Coffee = ____Wheat 1 Coffee = _____ Wheat 1 Wheat = ____ Coffee 1 Wheat = ____Coffee coffee 1 1/2 1 wheat 2 Wheat : BRAZIL has comparative advantage---produce only WHEAT Coffee : MEXICO has comparative advantage---produce only COFFEE Coffee BRAZIL 1000 1000 MEXICO 1000 500 Wheat Wheat

12. Theoretical Benefits of Free Trade BRAZIL MEXICO Coffee 1000 1000 .(300, 600) after trade Coffee .(700, 400) * (500,500) after trade * (250,500) 500 Wheat 1000 Wheat Trade Example: BRAZIL MEXICO 400 Coffee 0 Coffee 1,000 Wheat 1,000 Coffee 0 Wheat 300 Wheat There is not one right answer Any trade that produces a point ABOVE current PPF is efficient trade

13. Use Economic Logic! Betty- types 120 w.p.m. Jim- types 60 w.p.m. Assumption: No errors Who should do the typing? Betty or Jim? Betty & Jim

14. Betty has an absolute advantage in typing (she is more efficient) 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 is a lawyer & Jim is a secretary Betty- types 120 w.p.m. Jim- types 60 w.p.m. Betty earns $140 an hour. Jim earns $20 an hour. Now, who should type the letter?

15. 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

16. Theoretical Benefits of Free Trade BRAZIL MEXICO Coffee 1000 1000 .(300, 600) after trade Coffee .(700, 400) * (500,500) after trade * (250,500) 500 Wheat 1000 Wheat