Trade policies – free trade

This part of the paper attempts to provide a brief summary of David Ricardo’s concept of comperative advantage and Samuelson and Jones’ Specific Factor model, as well as indicating a comparison between the two, alongside with their merits and shortcomings.

In 1776, Adam Smith in his An Inquiry into the Nature and Causes of the Wealth of Nations illustrated how trade increase the welfare of nations who are engaged in trading with one another (Smith, 1776). While Smith’s work gained popularity, critisised merchantilism and promoted free trade, in practice many nations were still engaged with policies that imposed dfferent tariffs on exports and imports alike.

While Smith’s findings were based on the concept of absolute advantage, in 1817, David Ricardo came up with a model that provided evidence how trade between two parties could benefit both, even in the absence of absolute advantage. In contrast with Smith, Ricardo focuses on the comperative advantages of the countries. The principle of comperative advantage refers to phenomena when for instance a country produces two goods, and it can produce one of the goods at a lower relative opportunity cost than the than another country that is also engaged in the production of the same two goods. According to Ricardo, when both country became specialised in the production of a product they have comperative advantage, trading those goods on an estimated a relative price that is located somewhere between the two countries’ relative opportunity costs, would eventually result higher utility in both country (Krugman et al, 2011). In Ricardo’s classical example, he exaxmined the cloth and wine production of England and Portugal. The standard ricardian model assumed perfect competition, and contained only a few variables such as labour, cost of production, and the number of goods can be produced from their combinations.

For both countries there is a Possibility Frontier (shortly, PPF), a linear function, which shows all the combinations of good 1 and good 2, that a country could produce given their labour endowment and cost of production. If Home country has comperative advantage in producing good 1, and Foreign has CA in good2, meaning c1/c2 < c1 c2csillag, then trading can be executed at c1/c2 < P1P2< c1 c2csillag (Krugman et al, 2011)

The model implies that both countries benefit from the specialisation and the free trade. Furthemore, it also indicates that tariff imposed on export and import would increase the price of import goods, therefore the trade would be hindered.

While Ricardo supported the repeal of the 1815 Corn Laws, in the middle of the 19th century once they repealed it, the incoming imported grain drastically reduced the british market price for grain, and the british landowners were unable to keep up with the competetion, ultimately led them to bankruptcy. In contrast, the repeal of the Corn Laws benefitted the factory owners, since the reduce grain prices allowed them to decrease the employees’ wages.

According to Ricardo, free trade should have benefitted the whole country, nevertheless the historical evidence suggest otherwise. This failure of Ricardo’s model can be explained with it’s simplicity, as the labour was assumed to be the sole factor of production.

In order to eliminat the shortcomings of the ricardian model, Paul Samuelson and Ronald Jones (1974) further developed the concept and incorporated additional factors of production. This version of the ricardian model, commonly called Specific Factor model or 2 good 3 factor model, incorporates additional factors of production, such as capital or land, and these factors are assumed to be industry specific.The model is generally used to show how labour distribution ,factor returns and output level changes as a consequence of particular changes in the economy such as trade liberalization, or imposing tariffs.

When a factor is called specific it implies that it is immobile between sectors. In order to exemplify it, let’s say we have two industries, one of them produces leather bags and the other one produces strawberries. The machines being used in leather bag production are specific as they cannot be allocated to the strawberry industry. On the otherhand the strawberry fields, the sunshine or the agricultural devices can’t be moved to the leather bag industry either. The model however assumes that labour is mobile between the sectors, just like in the ricardian model. In addition, this model also assumes perfect competition and wages and prices are given. The PPF here is represented differetly, it is concave. The model assumes that the industries are aiming to maximise their profit, therefore they hire labour until the value of the last additional labour’s marginal productivity becomes equal to the wage to be paid. Specific factor model can be observed in the following example. If a country shifts to free trade, that might lead to the rise of a product eg. strawberries. Hence this sector becomes an exporter. In the beginning since wages are sticky in the short run, the recent increase in price will induce the industry to hire additional labour for the strawberry fields. In order to attract more labour, the strawberry producer must offer a higher wage. Hiring more labour they can produce more strawberries. In the same time, the leather bag industry is experiencing a reduction in their labour force, therefore they must increase the wage to keep their employees. In the strawberry industry as price and the labour increases, the value of the marginal product of capital has to increase, vis-à-vis the leather bag industry’s.

The Specific Factor Model, shows how trade increase welfare, and it is also highlights how income is diustributed between different sectors. In reality however, the Specific Factor Model is not the most accurate either, the Hecksher-Ohlin Model served to correct these imperfections.

Question 2

This part of the essay attempts to depict the role of japanaese trade policies behind the recovery and the miraculous rise of the country after World War II. After 1945, Japan losing their five biggest cities, consequently meant that they lost the 80 percent of the economy’s production capacity (Goto, 1990). Geographically Japan is very small and poor in natural resources, therefore in order to meet the demand for food and raw materials, Japan had to rely on high amount of imports (Mikio, 1994). In addition, in order to finance those imports requiring foreign exchange Japan to cover these needs increasing their exports. Due to Japan’s early Inclined Production Process plan, they were able to revive the coal and steel industry which allowed them to produce manufacturing products for export. It is true, that in the early phase of the recovery Japan imposed tariffs on both imports and exports, as they wanted to protect the domestic industries from competition, that cheap foreign prices could have caused. A good example is Japan’s imfamous car manufacturing, which has achieved a strong global recognition throughout the decades. After 1960, Japan announced an Income Doubling Plan, which contained an export expanding programme (Goto, 1990). However, in reality japanese prices were still higher than the foreign prices, which might have reduced the willingness to export. The government therefore set up incencentives that promoted export such as Pre-shipment export bill discount, tax system promoted exports. Furthemore the central bank kept the exchange rates low which further promoted trade. Thee measurment had a significant contribution in the rise of japanese companies such as Toyota to gain international recognition.

There is no single model which best describes and explains the events but the combination of two might help us to understand Japan’s trade policies. As we already know, the japanese agriculture were significantly less developed and less productive than Japan’s manufacturing. Therefore, the only product that Japan could realize on the international market were those goods, in which Japan was more productive in their production. When Japan enterred into the international market, the international manufacturing prices were still lower than the japanese. According to the Standard Trade Model, if a country’s exports are subsidized, while the country shifts their production to those products as a consequence of the increase in price, leading the Relative Supply rise and Relative Demand fall. Hence Japan’s Term of trade would decrease which results in a decline in welfare. Nevertheless, in Japan’s case we could see the opposite. The reason is, while Japan weas able to sell more and more manufacturing goods, which consequently led to an increasing economy of scale (Goto, 1990), meant the avarage cost of producing each unit decreased drastically. It is also important to note, that these evidences also correspond with the suggestion of the Specific Factor Model, which implies that trade could increase the welfare of a coutry. Nevertheless, there is also a change in how income is distributed among different industries.

In conclusion, in Japan’s case we could see how trade policy and thereby a shift to manufacturing resulted in welfare growth. However, it’s also important to note that the fast recovery not only the merits of the efficient trade policies, but is also connected to the strong civil service which bureaucratic apparatus helped execute Japan’s recovery plans.

Source: Essay UK - http://islam.business/essays/economics/trade-policies-free-trade/


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