The Global Free Trade Error

Certain factors, such as production technique and the availability of substitutes, can influence demand and supply. Technological advancements cut production costs, increasing both supply and demand (Schumacher 2013). Price substitutes may result in a variety of demand reactions. A country will engage in international trade by producing items that provide it a comparative advantage and importing goods from other countries in which it lacks a comparative advantage. As a result, worldwide specialization will occur, resulting in maximum exploitation of productive factors (Levchenko & Zhang 2016). However, protectionism seems to play a role In this overview, factors which affect the demand for SUV cars, including production technology and substitution effect, will be discussed in details in question one. Graphical illustrations and calculations will be used to adequately these factors affect the equilibrium quantity and price. Additionally, the response of Ford's SUV to Toyota's SUV will be analyzed by determining the cross elasticity of demand while the response to demand for SUVs due to a reduction in consumer incomes will be discussed by looking at the income elasticity of demand (Sabatelli 2016) This paper will critically examine the theory of comparative advantage, and it influences the policy of free trade in question two. The analysis will also discuss the framework upon which this theory works. Key assumptions which guide the application of this theory will be highlighted to enhance a deeper understanding of the underlying concepts.

Question 1

Improving production technology will lower the marginal costs of production (Brown & Calsamiglia 2014).This will translate in reduced input prices? Suppliers will have the incentive of producing more units at a cheaper cost (Hursh & Roma 2016). As prices fall, demand will increase which is consistent with the law of demand.

Advances in technology will make Ford produce SUV motors at lower cost, hence shifting the supply curve to the right. Rios et al. (2016) document that technological improvement will push down the costs of production and the supply curve will shift to the right. As a result, there will be an increase in the quantity produced at a particular price. Technology changes will cause the supply curve to shift to the right, which will consequently move the equilibrium price down. The most prominent effect of advanced technology is to increase production.

Price (Dollars) S0

P0 E0


P1 E1

Demand curve

Q0 Q1

Quantity (units)

Figure 1.1

Given the old production technology, initial equilibrium condition occurs at point E0, with P0 as the equilibrium price and Q0 as equilibrium quantity. When production techniques are improved, the costs of production decrease (Moon 2013). Lower costs of production give an incentive to produce more output. Due to reduced costs of production, Ford will be encouraged to manufacture more SUVs. The shift of the supply curve from S0 to S1 suggests an increase in supply. Equilibrium will be achieved where the new supply curve intersects with the demand curve, that is, at E1. At this point, equilibrium price becomes P1, which is less than the original equilibrium P0. The reduction in price is given by the absolute P1-P0. On the other hand, the quantity demanded increases from Q0 to Q1. The increase in demand will be given by Q1-Q0. From the graph, it can be deduced that technological advancement will drive down unit prices while increasing the quantity demanded. Word Count = 317

Figure 1.2

Before Toyota introduces a competing SUV car model, the original equilibrium point for Ford occurs at E0, with P0 and Q0 as the equilibrium price and equilibrium quantity respectively. In the presence of a substitute SUV car model from Toyota, the demand for Ford's SUV car model reduces as shown by the shift of the demand curve from D0 to D1 (Chambers & Echenique 2017). The new equilibrium will settle at E1, with P1 and Q1 as the new equilibrium price and new equilibrium quantity respectively. It is important to note that supply remains constant in the short run since there is no enough time to adjust to the changes in demand. The corresponding decrease in quantity will be given by Q0-Q1 while the corresponding decrease in price will be given by P1-P0. However, quantity demanded decreases by a larger extent than the corresponding decline in price, suggesting an elastic demand.

When Toyota introduces a SUV model car, similar to the one produced by Ford, this will create a perfect substitute for Ford's SUV model car. Given that the Toyota SUV car is cheaper relative to Ford's, consumers will shift their demand from Ford SUV to Toyota SUV. Due to the lower price for Toyota's SUV car model, demand for this model will increase, which depicts the law of demand. Holding other factors constant, consumers will exhibit their rational behavior when it comes to consumption (Zhang & Kim 2013). Since users will derive the equal amount of utility from the Toyota's SUV just like from Ford's, they will opt for Toyota's SUV, thus boosting the demand for Toyota SUV car model.

On the other hand, demand for Ford SUV car model will decrease since consumers will perceive the current price is relatively high. Consequently, the demand curve for Ford SUV car model will shift inward while supply will remain constant in the short run. Over the short term, since demand is decreasing and supply is constant, excess supply will arise (Kastanakis & Balabanis 2014). As one way of responding to the changes in demand, Ford will be forced to reduce its price and cut short its supply. The adjustments will result in a new equilibrium point, lower than the original equilibrium. At this new equilibrium point, the equilibrium price and the equilibrium quantity are considerably lower than the initial equilibrium price and quantity. The market will not clear until Ford and Toyota charge the same price. Therefore, for Ford to remain relevant in the market, it has to lower its price to the same level set by Toyota or less.

In the long run, Ford will adjust to the decreasing demand for its SUV by cutting down its supply. The supply curve will thus shift to the left, from S1 to S1, indicating a decline in production. To get compensation for revenue lost, it has to charge a higher price P1than the initial price P0.

Figure 1.3 below shows the changes in supply.


Price S0

P1 E1

P0 E0


Q1 Q0 Quantity

Combining both changes in demand and supply, we obtain the a new equilibrium at E3 as illustrated in Figure 1.4

Figure 1.4

We can calculate cross elasticity of demand to determine the degree to which Ford's SUVs respond to the new Toyota SUV (Lin & Zeng 2013).

Percentage change in quantity of Ford SUVs demanded

Cross elasticity of demand Ford, Toyota =

Percentage change in Toyota SUV price

Suppose the initial quantity demanded of SUVs was 100 cars and the new demand after the introduction of the Toyota SUV car is 80. If we suppose further that, the original price of a Toyota SUV was 20000 USD and the new price is 15000 USD, we can, therefore, calculate the cross elasticity of demand between Ford SUVs and Toyota SUVs as follows:

% change in the number of Ford SUVs demanded = [80-100] /100 *100= -20 %

% change in the price of Toyota SUV= [15000-20000] /20000 *100 = 80

We can interpret this result as follows:

When Toyota SUV car price reduces by 1 USD, the quantity demanded of Ford SUV car reduces by 80 cars.

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An increase in income, ceteris paribus, will increase demand (Sabadell 2016). Likewise, when income decreases, demand also decreases. Income is an absolute measure of consumer's purchasing power (Mohajeryami, Schwarz, & Baboli 2015). The higher the incomes, the higher the purchasing power. On the other hand, a reduction in income implies a lower purchasing power. In this case, if the incomes of SUVs consumers decrease, it means their purchasing power also goes down. Holding all other factors constant, their demand for SUVs will consequently decline. Demand for SUVs will decrease because, these consumers will find it costly to afford, and they will perceive the current prices as relatively high. As the law of demand states, a higher price will lead to a decline in demand (Nevo & Wong 2015). Given that supply remains constant in the short run, the price of a SUV car will reduce as well as the quantity demanded. As demand decreases, the demand curve for the SUVs will shift leftward. The price of a SUV will reduce along the supply curve. The new equilibrium point will occur where the new demand curve meets the supply curve. At this point, both price charged and the quantity demanded will be lower than at the original point. The effect of reduced incomes on demand for SUVs is illustrated in Figure 1.3.

Income D0 Supply curve


Px Ex

Py Ey

D1 D0

Qy Qx Quantity

Figure 1.3

At their original incomes, consumers are willing to buy Qx number of SUVs at price Px, and the market will clear at point Ex. Given a reduction in their income, their purchasing power decreases. Consequently, SUVs consumers will cut their expenditure on the number of SUVs demanded at price Px. Demand for SUV cars will, therefore, decrease following the decrease in income, causing a shift of the demand curve from D0D0 to D1D1. The market will clear at point Ey where the supply curve intersects with the resulting demand curve meets. The equilibrium price and equilibrium quantity will be given by Py and Qy respectively.

Any change in consumers' income will meet an appropriate response from some units demanded, which can be established through income elasticity of demand (Knittel & Pindyck 2016). Income elasticity of demand (EY) is the ratio at which quantity demanded changes to a change in income. It is determined using the formula:

EY = Change in quantity demanded expressed as a percentage

Change in income (percentage)

Suppose from the above graph, Px = 30,Py =20, Qx =100 and Qy =60, then income elasticity of demand will be calculated as follows:

EY = Ϫ % in quantity demanded / Ϫ % in income

= 100-60 30-20 = 40/100 ÷ 10/30

100 30

= 40/100*30/10 = 1.2

The value 1.2 means that, when the consumer decreases by one dollar, the demand for SUV car will decrease by 1.2 units.

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Question 2. The Theory of Comparative Advantage and how this theory leads to a policy of free trade

For a country to will have a comparative advantage in the production of particular good if the lowest opportunity cost is associated with the production of that good when compared to another country (Baiman 2017). Suppose Spain has comparative advantage in coffee production while Belgium possess a comparative advantage in wheat production, then the following condition must hold

The implication is that Spain must give up less wheat to produce an additional kilogram of coffee than Belgium will sacrifice to produce an extra Kilogram. It also suggests that the slope of the production possibility frontier Spain is steep compared to that of Belgium.

Cross multiplying the inequality will give the following:

This means that opportunity cost of producing Wheat for Belgium is lower than that of Spain. Similarly, Belgium is efficient in wheat production. Additionally, if Spain is comparatively advantaged to produce coffee, Belgium should be relatively advantaged to produce wheat. It means each country has an exclusive advantage in one of the items and not both.

If both countries are not comparatively advantaged in either of the items, then the following condition will hold:

However, such a scenario is not only rare but impractical.

The theory of comparative advantage postulates that economic welfare for all nations will improve if all the countries will focus on industries in which they have lower opportunity costs (Brakman & Van Marrewijk 2017).The benefits resulting from comparative advantage will reduce significantly in case local industries are subsidized or subjecting foreign enterprises to import tariffs. The theory of comparative advantage uses a framework with significant assumptions (Fenna 2016). Some of these assumptions are; there is no mobility of labor and capital between nations, trade imbalances are nonexistent, all resources are fully employed, and that international trade is subject to a comparative-static model. However, these assumptions not supported by concrete evidence and have evoked questions on their importance and adequacy.

It usually describes possible consumption behaviors of a country in the state of autarky (Levchenko & Zhang 2016). The slope of the PPF gives an absolute value of opportunity costs of a particular good express regarding another, commonly referred to as marginal-rate of transformation. Neoclassical economics assumes increasing opportunity costs, and this explains why the PPF is concave to the origin (Freund & Moran 2017). With available resources and technology, a nation can produce outside its PPF. Likewise, since resources are fully employed, it cannot produce inside the frontier. The actual production is determined through markets of demand, which is subject to social indifference curves. The economy's optimal production occurs at the point of tangency of the social indifference curve with the production possibility frontier. The rationale behind specialization and division of labor in international trade lies in relative advantages rather than the absolute advantages, which suggests that countries are better off to produce a good with a lower opportunity cost (Neary 2016). Ultimately, when countries specialize in the production of products at minimum opportunity cost, they will realize production efficiency (Schumacher 2013).

Comparative advantage principle demonstrates that international free trade leads to increased output and income than in the absence of commerce (Schumacher 2013).In other words, free trade can make the nation to achieve greater output and consumption rather than in isolation. When the market is perfectly competitive, free trade achieves optimal allocation of resources across nations. Free trade, therefore, plays a critical role to establish equilibrium between the marginal production and marginal consumption in participating countries. In contrast, this equilibrium condition is not realized since trade barrier creates divergences in international and domestic prices. Hence, trade barriers create some degree of protectionism which leads to a sub-optimal allocation of factors of production across countries and a considerable reduction in real world income unlike under free trade (Watson 2015). The most notable consequence of protectionism is that it helps in income redistribution. While protection generates substantial gains for some industries, it also results in significant losses to others.

Government policies aimed at protecting local industries against foreign competition have increased debates on free trade as well as the rationale for economic policy (Do et al. 2016). International economists have argued that the policy of free trade is pre- requisite for international competition. Substantial evidence and theory suggest that, if countries engage in free trade, increased incomes are likely to be realized and there will be an even distribution of such earnings. Watson (2017) argues that, if individuals, firms or nations fail to recognize their comparative advantage, their efficiency will deteriorate and their efforts to specialize will be highly disadvantaged. Protectionism greatly undermines free trade and beneficial effects associated with comparative advantages have not been fully exploited. Categorically, protectionist policies restrict international trade, lower national incomes and distribute revenues more unevenly. Since protectionism through tariffs, quotas and other measures have negatively impacted on many economies, economists have persuaded governments to relax protectionism as the expense of free trade.

A country can also obtain a comparative advantage through the resources at its disposal. Under some controlled conditions, comparative advantage can occur due to different relative factor endowments among nations (Self & Becker 2016). A country will be comparatively advantaged in producing a good only if that good utilizes the relative abundant resource more efficiently. Countries will, therefore, transfer resources to where they can be used more effectively. By having each country specialize in what it produces best at the minimum relative cost, trade between countries will develop and both countries stand to gain mutually from that trade(Freund & Moran 2017). Additionally, countries, where human skills are relatively abundant, possess a comparative advantage in those commodities whose production require intensive human skills. Certain products, for example, electronics utilize highly skilled work force, which includes engineers, designers, and programmers. Such products are likely to gain a comparative advantage if they produced in countries such as China and Japan, technical skills are relatively abundant. As such, these countries will reap massive benefits from international trade if they specialize in production and export of electronics

Demands patterns and size of domestic market play a critical role in establishing economies of scale, the terms of trade equilibrium and has helped develop product cycle hypothesis (Meoqui 2014). Home market demand contributes to the success of international markets. Manufacturers often launch a new product to meet the needs of the local market. Hence, they adopt the relevant skills necessary to make the product using more efficient technology, which will ultimately give these countries some comparative advantage in that product compared to other countries. Comparative advantage in the presence of market imperfections and high product differentiation will account for a large fraction of intra-industry trade between industrialized nations (Pflüger & Tabuchi 2016).

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The elasticity of demand is vital element while designing the pricing models for different products. Goods whose demand is elastic demand because significant changes in quantities demanded. Since Ford's SUV and Toyota's SUVs are perfect substitutes, the reduction in the price of Toyota SUV car will to a large extent decrease the quantity demanded of Ford's SUV cars. Additionally, changes in consumers' income will lead to a decline in demand, holding other things constant. A reduction in income suggests a decline in the purchasing of consumers, which means they may not afford to purchase the quantities they demanded previously. While some countries are well endowed with natural resources, others are provided with abundant capital and labor resources. In the absence of free trade, a country will be forced to produce all commodities it requires regardless of the costs involved. Hence, the theory of comparative advantage advocates that nations to specialize in what they produce best at the lowest opportunity best and import what they cannot produce more efficiently (Brakman & Van Marrewijk 2017). Comparative advantages are ascertained through comparing opportunity costs of different nations at their optimal production. If specialization of the country is based on its comparative advantage, the overall production is likely to increase. Through trade, large quantities will be produced in both nations which are not guaranteed in autarky state. National consumption will thus increase beyond a given production possibility frontier, such that each country can experience a higher social indifference curve. As a result, peculiar needs of consumers are met to a larger extent. In this way, each nation will benefit from free international.

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