Basic Instruments: The Theory of Trade and the EU

1. The European Union: economics, policies and history 1st edition Chapter 4 Basic Instruments: The Theory of Trade and the EU Susan Senior Nello

2. The main arguments in favour of free trade: Absolute advantage ‘What is prudent in the conduct of every private family can scarce be folly in that of a great kingdom. A family will not make at home what it costs less to buy from outside. A taylor (sic) will not make his own shoes, but will buy them from a shoemaker.’ Adam Smith

3. The main arguments in favour of free trade: Absolute advantage With two nations, if one country is more efficient in the production of one good, and less efficient in the production of the other, then each country should specialise in the production of the good where it has an absolute advantage. In practice Smith’s concept of absolute advantage explains only a small share of international trade.

4. The main arguments in favour of free trade: Comparative advantage • David Ricardo: even when one country is less efficient in the production of both goods there is a basis for mutually beneficial trade. • Even if one country has an absolute disadvantage in the production of both goods, it should specialise in the production and export of the good where its absolute disadvantage is smaller and import the product where its absolute disadvantage is greater.

5. The main arguments in favour of free trade: Comparative advantage • The country with an absolute advantage in the production in both goods should specialize in the production and export of the product where its absolute advantage is greater, and import the good for which its absolute advantage is smaller.

6. The Heckscher-Ohlin Theorem • Tries to explain the pattern of comparative advantage between countries. • Why does a country have a comparative advantage in the production of a particular good? • According to this approach, trade can be explained by the pattern of endowment of countries with different factors of production.

7. The Heckscher-Ohlin Theorem Fig 4.1

8. Intra-industry trade and product differentiation • Intra-industry trade consists of exports and imports of the same product or group of products. • It is the result of product differentiation as products are substitutes for each other, but are slightly different.

9. Intra-industry trade and product differentiation • The firm or plant can therefore specialise in a few varieties of the products, so can make use of longer production runs, more specialised machinery and labour, and so on. Other varieties of the product can be imported so consumers may have a wider range of products available at lower prices.

10. Static economies of scale • Occur when an increase in the use of inputs results in a more than proportional increase in output. In other words, the unit costs of production fall as the scale of production rises. • A classic example is the assembly-line production introduced by Henry Ford.

11. Static economies of scale • A highly simplified model based on two countries 1 and 2 and two products X and Y, and two factors of production can be used to illustrate Static economies of scale. Fig 4.2

12. Dynamic economies of scale • Dynamic economies of scaleare associated with the learning process. • The learning process refers to the unit cost advantage that accrues to a firm because of the experience it acquires through cumulative production of goods and services. • The fall in cost may be due to technological improvements; better organisational structures and/or performance of workers.

13. Dynamic economies of scale • The firm which first moves down the ‘learning’ curve of a strategic industry will gain a cost advantage over its competitors. • Economic policy should therefore ensure that markets are on an adequate scale to allow such learning effects to be exploited. • The existence of these experience economies may render it difficult for new entrants to enter the market.

14. Dynamic economies of scale Fig 4.3

15. Tariffs • Up until the WW1 it was widely accepted that if trade barriers were introduced for protectionist purposes they should be confined to tariffs. • In the GATT/WTO context tariffs are considered the ‘lesser evil’ compared with other trade barriers because they are more transparent. • The GATT/WTO favours the conversion of other non-tariff barriers into tariffs.

16. The economic effects of introducing a tariff in a ‘small nation’ Fig 4.4

17. The effect of introducing a tariff in a ‘large nation’ Fig 4.7

18. The import demand of the home country Fig 4.8

19. The import supply of the home country, or the export supply of the foreign country Fig 4.9

20. The effect of a tariff on the home and foreign countries Fig 4.10

21. Non-tariff barriers and the ‘New Protectionism’ • From the 1970s international trade became increasingly subject to non-tariff barriers (NTBs) • Main non-tariff barriers: • quotas on imports; • voluntary export restraint agreements (VERs); • cartels; • anti-dumping duties; • export subsidies; • differences in standards and technical specifications, and administrative measures; and • discrimination in public procurement.

22. The main arguments presented in favour of protection • Protectionism may be advocated for non-economic reasons, such as for defence, national pride or to further foreign policy objectives. • The infant industry case protecting a new industry until until it is large enough to compete with foreign firms.

23. The main arguments presented in favour of protection • According to the optimal tariff argument, if a large nation introduces a tariff on a good widely used, the world price would fall. As a result, foreign producers would bear part of the cost of the tariff. • The senescent industry maintains that protectionist measures may be necessary to avoid unemployment.

24. Second best • Second best implies that if the conditions of perfect competition are violated in some part of the economy. • It need not be optimal for the rest of the economy to attain a perfectly competitive equilibrium. In other words, it is not possible to know whether the introduction of an additional distortion will increase (while still remaining in a suboptimal situation) or reduce total welfare.

25. Second best • In the context of the debate on protectionism this implies that it is impossible to say a priori whether a move towards free trade will improve the situation, or that the introduction of a protectionist measure will worsen it. Under such conditions it is necessary to examine the specific case in question to decide on the most appropriate policy.

26. More recent arguments in favour of protection: Strategic Trade Theory • According to Strategic Trade Theory, a government may create a competitive advantage for its firms in high-technology industries through temporary protection, subsidies and tax breaks. • Strategies to promote investment in infrastructure, people, and research and development may also play an important role.

27. More recent arguments in favour of protection: Strategic Trade Theory • This approach shares many of the shortcomings of the infant industry argument: choosing which sectors will be future winners is difficult, and too much government intervention may invite similar measures by major competitors.

28. The political economy of protectionism • The expected benefits to producers from protection are generally relatively high and may be sufficient to induce them to take on the costs of lobbying governments to introduce protectionist measures. • The costs of lobbying include the time, effort and expense needed to obtain information, organise a pressure group, signal preferences, and carry out lobbying activities.

29. The political economy of protectionism • The cost to consumers of the higher prices as a result of protection may not be sufficient to induce them to organise any kind of protest. • The government may have an incentive to give in to the requests of the producer lobby, knowing that consumers will be unlikely to organise any kind of effective resistance.