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Advanced International Trade : Theory And Evidence Method

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Question:

Discuss about the Advanced International Trade for Theory and Evidence.
 
 

Answer:

Comparative advantage of a country emerges when it is able to produce a product or a service at an opportunity cost, which is lower than any other country. In other words, a country will specialize in the production of a particular good or service, which it can produce at a relatively cheaper cost than others. The comparative advantage theory states that there would be a rise in the economic welfare if the countries can specialize in the production of goods at the lowest opportunity cost (Levchenko and Zhang 2016). Hence, according to the question, Australia has comparative advantage in production of beef and Japan has comparative advantage in production of cars. Hence, Australia will specialize in beef production and Japan will specialize in car production. Thus, Japan would export cars and import beef.

Australia does not have comparative advantage in car production. Hence, the equilibrium price is P* for quantity Q* in the car market. When there is free trade between Australia and Japan, Australia imports more cars due to lower cost of cars in Japan. Hence, the supply of cars increases resulting in the rightward shift of the supply curve from S1 to S2. Under free trade, the supply increases more than the demand and price falls to free market price P1. The domestic supply is Q1 and the imported quantity is Q2-Q1. The total supply is more than the equilibrium production Q* and price is below the domestic equilibrium price P*.

Initially the consumer surplus was the area AE*P* and producer surplus was P*E*B. when the supply increases with free trade, both the surplus increase. Due to lower price, consumer surplus increases and shown by the area AE2P1. Producer surplus increases due to increase in sales, and shown by the area P1E2B1.

 

As per figure 1, before trade, the equilibrium was at point E*, corresponding to price P* and quantity Q*. After trade happens, the quantity supply increases from Q* to Q2 and domestic price falls due to comparative advantage. It is evident from the above diagram, that before trade the total surplus (consumer surplus + producer surplus) was the sum of the two triangles, AE*P* and BE*P*, that makes the total surplus, shown as the triangle AE*B (Campbell and Brown 2016).  After trade, as the supply curve shifts rightwards, the consumer and producer surplus both increased. The total surplus area became the triangle AE2B1. Thus, Australia definitely gains from the trade.

At free trade the supply curve was S1, and equilibrium market price is P*. The domestic demand is QD1 and domestic supply is QS1. The excess supply i.e. QD1 - QS1 is the amount of import at free trade. The area AE1P* is the consumer surplus and BE1P* is the producer surplus. Now, the government imposes a tariff (T) on the imported goods. After the imposition of tariff, the price rises from P* to PT by the amount of tariff T. Due to this price hike, domestic demand declined from QD1 to QD2. The new equilibrium is at E2, which is higher than the free trade equilibrium E1. The imposition of tariff increases the price of imported goods (Cruz and Bussolo 2015). Hence, the level of import decreases, shown by the quantity supplied QS2, and after tariff, the import is QD2 - QS2. Thus, the consumer surplus decreases, shown by the area AE2PT and producer surplus also decrease, shown as B2E2PT.

The total surplus is the total of consumer surplus and producer surplus. Before the tariff, the total surplus was shown by the area AE1B1. After the imposition of tariff, the price rises to PT and both the consumer and producer surplus decrease (Campbell and Brown 2016). The new surplus area is shown as AE2B2. Thus, Australia does not gain much from the imposition of tariff.

 

References:

Campbell, H.F. and Brown, R.P., 2016. Consumer and producer surplus in cost-benefit analysis.

Cruz, M. and Bussolo, M., 2015. Does input tariff reduction impact firms' exports in the presence of import tariff exemption regimes?.

Feenstra, R.C., 2015. Advanced international trade: theory and evidence. Princeton university press.

Levchenko, A.A. and Zhang, J., 2016. The evolution of comparative advantage: Measurement and welfare implications. Journal of Monetary Economics, 78, pp.96-111.

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