International Trade, Comparative Advantage, and Protection

a) Explain how the opening up of trade between two countries leads to specialisation when costs are constant.

Because economic resources are limited, and every country is faced with a production possibility frontier, every time a decision is made as to what to produce, there are many alternatives foregone. To examine how this opportunity cost can be partially overcome through international trade, it is best to examine a model in which there are only two goods produced by two countries. Let us call the goods food and clothing, and the countries A and B. This model will demonstrate the law of comparative advantage, which states that countries will specialise in producing and exporting the goods in which they have a comparative advantage, i.e. in which the relative price is lower than in the other country. The law was first cited by British economist David Ricardo in the early 19th century.
In Table 1, we see the different unit labour requirements needed to produce x units of food and clothing in each of countries A and B (the unit labour requirement is the number of hours of labour required to produce x units of the good). We can see that in country A, it takes five hours to produce x units of food (say one tonne) and twenty hours to produce x units of clothing (say a bundle of ten garments). In country B, the figures are ten hours per tonne of food and fifteen hours per bundle of garments. Assuming that each country has 100 hours of labour time available, and allocates each equally between production of food and clothing, this means that country A will produce ten tonnes of food and country B five, giving a world output of fifteen tonnes. For clothing, country A will produce 2.5 bundles, and country B 3 1/3, giving a total of 5 5/6 bundles of clothing in total.
These figures show us that in absolute terms, country A can produce food more efficiently, and country B can produce clothing more efficiently. However, trade is not based on absolute advantages, but comparative advantages as already noted. Thus we need to examine the opportunity costs of production in each country.
For country A, the opportunity cost of producing one tonne of food is 1/4 of one bundle of clothing, whereas for country B it is 1/3. We say country A has the comparative advantage in the production of food, because it must give up less clothing in order to produce one extra tonne of food. The situation is reversed for clothing, where country A must sacrifice four tonnes of food to produce an extra bundle of clothing; on the other hand, country B must only give up 1 1/2 tonnes of food. If suitable terms of trade are agreed, then country A will produce food, and country B clothing. This will mean that each country will devote its full 100 hours of labour to production of the commodity in which it has a comparative advantage. This will raise world output as shown in table 2; total output is now twenty tonnes of food and 6 2/3 bundles of clothing. This targeting of resources is known as specialisation.
The theory of comparative advantage makes many simplifying assumptions. Firstly, it assumes that there are no transport costs, when in reality, these do of course exist, and will serve to reduce and potentially eliminate comparative advantage. It also says that costs are constant and thus there are no economies of scale. In practice, specialisation is likely to lead to increasing returns, which will reinforce the benefits as firms' costs fall. Thirdly, we have already stated that there are only two economies producing two goods; however, the same theory applies equally to a world that has many economies each producing a large number of traded goods. Fourthly, these goods are homogenous, and there is perfect knowledge of where they can be found cheapest internationally. Finally, there are no tariffs or other trade barriers, and factors of production are assumed to be perfectly mobile. In short, there is a general assumption that all firms in the economy are operating under conditions of perfect competition. However, this is not the true situation in most cases; some form of imperfect competition is prevalent, and these assumptions must be modified.

b) When costs are increasing (why should they?) is the same true?

By removing some of the assumptions made in the theory of comparative advantage above, we will introduce extra or rising costs into the situation. Firstly, as already noted, the imposition of transport costs will increase average costs. Not only that, but the further apart geographically the two countries are, the higher these are likely to be. Because firms now have these costs to pay, they will be less productive, so for a given amount of resources, production will be lower.
Costs were assumed to be constant above. If they were not, there could either be increasing or decreasing returns to scale. It could be the case that the economy was already producing at its optimum level of output before specialisation and trade took place. The result would be that costs would rise as all factors of production were devoted to making one product, as a result of the managerial diseconomies of scale incurred.
Thirdly, it is clearly impossible that there is perfect knowledge as to where all commodities can be found at their cheapest prices in the world, as few, if any people know this. There is also clearly not great factor mobility in either land, labour, capital, or enterprise. This means that in order to expand production, firms must bid up prices for their factor inputs, and this will raise their costs.
To generalise, if the economy is operating under imperfect competition (monopoly, oligopoly, or monopolistic competition), there will be profits for firms. Any abnormal profits will attract new firms into whatever industry is concerned. Making the assumption that there is a fixed level of sales that can be met in the export market, or supposing an aggregate demand shock in foreign countries that causes demand to fall for exports, this means that each firm will sell less output, and consequently their costs will rise. The overall effect of any of the above mentioned changes will be to reduce productivity; if this only happens in one country (transport costs will affect both) or disproportionately in one (but transport costs might be disproportionately high in one country, perhaps due to a poor infrastructure), then this will reduce the output per factor inputs, which could negate any comparative advantage. In terms of our example, there may develop a situation where A loses its comparative advantage in the production of food. In this case, there will still be trade, as B will produce that which it is best at, and A that which it is "least bad" at. However, the overall effect will be to reduce world output.

c) Explain how economies of scale can lead to intraindustry trade.

To see this we must refine our assumptions made in examining comparative advantage. We will still have only two countries producing two products, but the products will be manufactured goods and food in this case. We will also say that country A is endowed with capital resources, which makes it better to produce the manufactured goods, whereas country B is rich in labour, and will have the comparative advantage in the production of food. If these were perfectly competitive industries, it would be obvious that A would produce the manufactures and B the food, but we are making a further assumption that there exists monopolistic competition in the manufactures industry, the key difference being that in our modified model there are differentiated products; thus while all manufactures are substitutable, there are different brands to choose from.
The way economies of scale affect the situation is as follows. As each country expands its production of manufactures, it will benefit from economies of scale. These will lower costs for the firms in that industry and may attract more firms into it, thus increasing the variety of manufactured goods on offer (as each new firm makes a different type of good). As neither country can make the entire range of manufactures on its own, there is always going to be some production of them in the other country. Given that there exists demand for country B's manufactures in country A, country B will export some manufactures as well as food to country A. This is known as intraindustry trade, and it is not reflective of comparative advantage. Even if both countries could produce manufactures as cheaply as one another, there would be this type of trade, as the products they are making are differentiated. Thus it is the demand for variety stemming from customers that generates intraindustry trade, in combination with the economies of scale that allow new firms to enter the industry and produce differentiated products. The more similarly endowed the two countries are in terms of capital-labour ratios, the more intraindustry trade there will be.
Intraindustry trade accounts for a quarter of the world's trade, and is particularly important among the trade of manufactured goods between developed countries. Over time, these countries have developed similar levels of skill in the workforce and technological expertise. It is because of these similarities that there is often no clear comparative advantage within the industry, and so the drive behind trade are the benefits from economies of scale rather than specialisation from comparative advantage.

d) What are the costs and benefits of protection by tariffs?

A tariff is a tax levied on foreign imports; it can be either specific (i.e. a fixed charge for each unit of a good imported), or ad valorem (i.e. a percentage of the value of the imported goods).
Introducing a tariff on an imported good has the effect of raising the price that domestic consumers must pay for the good above the world price, and lowering the price for people in other countries due to the excess supply there is now that their exports are limited. This is illustrated in diagram 1; the world price is pw, but the tariff has raised the price of the good to pw+t. The new price for the rest of the world is prow. This has two effects; firstly, more firms in the domestic economy will produce the good as the price has risen. Thus supply rises from S0 to S1. Secondly, domestic demand falls from D0 to D1. This has the overall effect of reducing imports from S0D0 to S1D1 as shown.
Diagram 2 shows the costs and benefits of a tariff. Consumers lose out, as their consumer surplus is reduced due to the higher price. This is shown by the area abcd. On the other hand, producers' surplus has risen because of the increased output at home - this is indicated by the area aefd. The government also gains revenue from the tariff; the revenue rises by the area ebgh. If the country is small, and the world price does not fall due to the tariff, then prow=pw, and the lower section of the gain in revenue will not exist.
There are welfare implications of a tariff for the country imposing it. The two areas where there is waste are efi and bcj respectively. The area bci is wasteful because it is the extra money that society spends by producing cars domestically which could be imported at the world price. Were there no tariff, the companies producing at this price would go bust; thus there is inefficiency here. The area bcj represents the waste due to under consumption of cars that results from the fall in demand. These two areas combined are known as a dead-weight loss. The benefit to the terms of trade given by the area ijgh may act to offset these inefficiencies, but this is dependent on the country being able to affect the world price as already mentioned; a small country would not be able to do this, and would thus lose out in welfare terms were it to impose the tariff.
What then are the arguments for the imposition of tariffs if they are likely to lead to a welfare loss? These fall under several headings: first-best, second-best, strategic, and non-arguments for tariffs. The first-best argument says that the world price can be bid up by having too many imports, and imposing a tariff is the best way to bring the benefits from the purchase of the import in line with its cost to society. The second-best arguments include the idea that traditional ways of life should be protected from cheaper foreign competition, that new infant industries should be allowed to establish themselves in the industry before being exposed to hostile foreign competition, that defence considerations mean those home industries producing armaments should keep producing, that it is unfair that luxuries should be available only to a rich few, and simply to collect revenue for the government. Some of these objectives can be more easily achieved by way of methods other than tariffs, such as consumption taxes or production subsidies. Thirdly, the strategic arguments offer an application of game theory to international trade, where tariffs are imposed to prevent foreign industries from entering a market; this can lead to trade wars. Finally, there are the non-arguments, which are often recited, but are fallacious. The main one is that tariffs are necessary to protect home industries from cheap foreign labour. However, this fails to recognise that countries' comparative advantages change over time, and that propping up an industry in which a country has lost its comparative advantage is futile; resources would be better allocated identifying and shifting production to the areas where the country's new comparative advantage(s) lie.