Special supplementary slides on free trade & trade theory

1. Special supplementary slides on free trade & trade theory

2. Economists believe in free trade because free trade allows businesses and nations to find their comparative advantage • If a country has comparative advantage in something, economists believe it should succeed without subsidies

3. “Free trade” means no barriers • The principle: You should have the same incentives when you consider a product from abroadas from your home country.

4. An industry in which a nation has comparative advantage is an industry in which that country produces relatively efficiently (compared to other industries in that country). • All nations have comparative advantage in something

5. Your country has comparative advantage in the product or service where the ratio Resources required in your country . Resources required in the other country is low

6. Free trade theory is based on some basic free-market economics • Two fundamental principles • The price for which sellers are willing to sell a product indicates what all the resources to produce (and sell) it are worth. • The price for which buyers will buy indicates what the product is worth to the buyer • So economists think anything that manipulates prices is dangerous

7. Economists prefer income taxes or sales taxes (on everything) rather than tariffs (on particular imports) • For any given amount of revenue raised, income and sales taxes disrupt the market less than tariffs

8. Most economists only make 1 or 2 exceptions • Exception 1: tariffs to protect infant industries • These are industries that lack comparative advantage, but could develop it soon • Example: Textile manufacturing in Vietnam in the 1980s • Because few Vietnamese were experienced in textile manufacturing, it was relatively less efficient than rice-growing • But as Vietnamese got experienced, they soon learned to produce textiles efficiently

9. Exception 2: strategic trade policy • Sometimes when a brand new industry is invented, people can recognize • It will have economies of scale (the people that produce most will produce cheapest) • There will be big learning effects (the people who produce first will produce cheapest) • So subsidies may be worthwhile • Example: flat-panel computer displays when they had just been invented

10. Smith, Ricardo and their successors advocated free trade • They believed that if people were left to trade on their own, they would naturally trade the goods in which their countries had comparative advantage • “Every individual seeks the most advantageous employment for his capital…. • “Study of his own advantage necessarily leads him to prefer that employment most advantageous to society” - Adam Smith, 1776

11. In the 19th century, free trade was widely practiced • In Europe, tariffs were low or non-existent • But after WW I and especially in the early 30s, nations raised tariffs to protect their domestic economies • A disastrous depression followed

12. GATT was created to prevent the mistakes of the 30s from repeating • It provided a framework for negotiating reductions in tariffs and non-tariff barriers • The WTO continued the process and provided an enforcement mechanism to prevent new barriers

13. So – tariffs are notfree trade • The WTO (and almost all economists) discourage use of tariffs • to raise funds • to protect an industry that already has comparative advantage • In the homework question, answers suggesting tariff protection for handmade blankets and wool would not get WTO support