Download The Gains from International Trade

INTERNATIONAL
TRADE
22
CHAPTER
Silk Routes and Sucking Sounds
Since ancient times, people have expanded trading as far
as technology allowed – Marco Polo’s silk route between
Europe and China is an example.
Many people fear free trade because they think that
domestic industries may suffer. Some predicted a giant
“sucking sound” as jobs were transferred from high-wage
Ohio and Michigan to low-wage Mexico under the NAFTA.
Why do we trade with other nations?
Do tariffs that restrict trade bring any benefits?
Do they bring costs? Who gets the benefits, who bears
the costs?
Patterns and Trends in International
Trade
Imports are the goods and services that we buy from
people in other countries.
Exports are the goods and services we sell to people in
other countries.
Patterns and Trends in International
Trade
Net Exports and International Borrowing
The value of exports minus imports is called net exports.
As we know, negative net exports imply international
borrowing.
Positive net exports on the other hand imply international
lending.
The Gains from International Trade
Comparative advantage is the fundamental force that
generates trade between nations.
The basis for international trade is different opportunity
costs in different countries.
Nations can increase their consumption of goods and
services when they allocate resources to the production of
those goods and services for which they have a
comparative advantage.
The Gains from International Trade
Opportunity
Cost in
Farmland
This Figure
shows the
production
possibilities
frontier for an
imaginary
country called
Farmland.
The Gains from International Trade
Without
international
trade,
Farmland
produces and
consumes 15
billion bushels
of grain and 8
million cars at
point A.
The
opportunity
cost of a car is
9,000 bushels
of grain.
The Gains from International Trade
Opportunity
Cost in
Mobilia
This Figure
shows the
production
possibilities
frontier for
another
imaginary
country
called
Mobilia.
The Gains from International Trade
Without
international
trade, Mobilia
produces and
consumes 18
billion bushels
of grain and 4
million cars at
point A'.
The
opportunity
cost of a car is
1,000 bushels
of grain.
The Gains from International Trade
Comparative Advantage
Cars are cheaper for Mobilia to produce than for Farmland,
because less grain is given up to produce each car.
Grain is cheaper for Farmland to produce than for Mobilia
because fewer cars are given up to produce each bushel.
A country has a comparative advantage in producing a
good if it can produce that good at a lower opportunity
cost than any other country.
Farmland has a comparative advantage in producing grain,
and Mobilia has a comparative advantage in producing
cars.
The Gains from International Trade
The Gains from Trade: Cheaper to Buy Than to Produce
If Mobilia bought grain for the price that Farmland produces
it, Mobilia could buy 9,000 bushels of grain for 1 car—a
much lower price than the opportunity cost of producing
grain in Mobilia.
If Farmland bought cars for what Mobilia pays for them,
Farmland could buy 1 car for 1,000 bushels of grain—a
much lower price than the opportunity cost of producing
cars in Farmland.
The Gains from International Trade
The Terms of Trade
The quantity of grain
that Farmland must pay
Mobilia for a car is called
Farmland’s terms of
trade with Mobilia.
This Figure shows how
the forces of
international demand
and supply determine
the terms of trade and
the volume of trade.
The Gains from International Trade
With no international
trade, Mobilia can
produce a car for
1,000 bushels of
grain, so at that
price, it plans to sell
no cars to Farmland.
But as the price
rises above 1,000
bushels of grain per
car, the quantity of
cars supplied by
Mobilia increases.
The Gains from International Trade
With no international
trade, Farmland can
produce a car for
9,000 bushels of grain,
so at that price, it
plans to buy no cars
from Mobilia.
But as the price falls
below 9,000 bushels of
grain per car, the
quantity of cars
demanded by
Farmland increases.
The Gains from International Trade
The equilibrium
terms of trade
(price) is 3,000
bushels of grain
per car and 4
million cars are
exported by
Mobilia and
imported by
Farmland.
The Gains from International Trade
Balanced Trade
The number of cars exported by Mobilia equals the number
of cars imported by Farmland. Farmland pays Mobilia with
12 billion bushels of grain (four million cars multiplied by
3,000 bushels for each car)—Mobilia imports and Farmland
exports 12 billion bushels of grain. Trade is balanced.
For each country, the value of exports equals the value of
imports—4 million cars are worth the same as 12 billion
bushels of grain.
The Gains from International Trade
Changes in Production and Consumption
Farmland buys cars at a lower price than it would pay if it
made them itself, and sells its grain at a higher price.
Mobilia buys grain at a lower price than it would pay if it
grew the grain itself, and sells its cars at a higher price.
Everyone gains from trade.
The production possibilities frontier illustrates the
production possibilities of a country, but it does not show
the consumption possibilities of a country that engages in
international trade.
The Gains from International Trade
This Figure shows how both countries gain from trade.
The Gains from International Trade
Calculating the Gains from Trade
Farmland increases its consumption of both cars and grain
by decreasing car production and increasing grain
production until its own opportunity cost of producing cars
equals that of the world terms of trade and exchanging
grain for cars at those terms of trade.
Mobilia increases its consumption of both cars and grain by
increasing car production and decreasing grain production
until its own opportunity cost of producing cars equals that
of the world terms of trade and exchanging cars for grain at
those terms of trade.
The Gains from International Trade
Gains for All
Both countries gain by consuming output combinations outside
their respective production possibilities frontier.
Overall, trade does not create winners and losers; it creates only
winners.
Farmers selling grain and Mobilians selling cars face increased
demand and higher prices.
Farmers buying cars and Mobilians buying grain face increased
supply and lower prices.
But how about farmers in Mobilia and autoworkers in Farmland?
They may lose …
The Gains from International Trade
Gains from Trade in Reality
Gains from trade occur in the real global economy.
The United States buys, e.g., TVs and Blue Ray players from
Korea, machinery from Europe, and fashion goods from Hong
Kong, in exchange for, e.g., machinery, grain, lumber, airplanes,
computers, movies and TV shows, and financial services.
Everyone who buys these things gains from trade, because they
get them cheaper than they otherwise would.
The combination of diverse preferences and economies of scale
also create comparative advantages that generate large volumes
of international trade in similar but differentiated products.
International Trade Restrictions
Governments restrict international trade to protect domestic
producers from competition by using two main tools:
 Tariffs
 Nontariff barriers
A tariff is a tax that is imposed by the importing country when an
imported good crosses its international boundary.
A nontariff barrier is any action other than a tariff that restricts
international trade. The simplest, and the only ones we will discuss
in any detail, are so-called ‘quantitative restrictions’ or quotas and
voluntary export restraints. There are many, many, ‘other NTB’s’
in the real world, e.g., Thousands of detailed health, safety, and
other regulations restrict international trade.
International Trade Restrictions
In 1994, the United States became party to the North American
Free Trade Agreement (NAFTA), under which trade barriers
between Canada, Mexico and the United States are being
lowered.
The European Union (EU) is an organization of European
countries that have eliminated trade and other economic
barriers amongst themselves.
The Asia-Pacific Economic Council group (APEC) has another
agreement to reduce trade barriers among East Asian countries,
including China.
There are other regional groupings elsewhere in the world e.g.
SAARC (South Asian Association for Regional Cooperation) SAFTA – South Asian Free Trade Area)
International Trade Restrictions
How Tariffs Work
Tariffs increase the
price that consumers
of the importing
country must pay for
imported goods or
services.
This Figure uses the
Farmland and Mobilia
example to illustrate
the effects of a tariff on
car imports into
Farmland.
International Trade Restrictions
The supply of cars
to Farmland
decreases
because the tariff
must be added to
the price at which
Mobilia is willing
to supply a given
quantity.
The price rises, the
quantity falls, and
the government
collects the tariff
revenue.
International Trade Restrictions
The supply curve shifts leftward and the vertical distance
between the free-trade supply curve and the new supply
curve equals the amount of the tariff.
The price of a car in Farmland rises.
The quantity of cars imported by Farmland decreases.
The Farmland government collects tariff revenue.
In this two-good two-country example, the value of exports
changes by the same amount as the value of imports and
trade remains balanced.
International Trade Restrictions
Non-tariff Barriers
There are two fairly simple non-tariff barriers to trade.
A quota is a quantitative restriction on the import of a
particular good, which specifies the maximum amount of
the good that may be imported in a given period of time.
A voluntary export restraint (VER) is an agreement
between two governments in which the government of the
exporting country agrees to restrain the volume of its own
exports to that particular importer.
International Trade Restrictions
How Quotas
and VERs
Work
This Figure
uses the
Farmland and
Mobilia
example to
illustrate the
effects of a
quota on
automobiles
imported into
Farmland.
International Trade Restrictions
The quota limits
the quantity that
may be imported.
At the quota
quantity, buyers are
willing to pay more
than the price that
sellers are willing to
accept.
Importers profit by
buying at a lower
price than the price
at which they sell.
International Trade Restrictions
With competitive
markets, a quota can
generate the same
price, quantity, and
inefficiency as a tariff,
but with a quota, the
importer makes an
economic profit equal to
what the government
receives as tariff
revenue with a tariff.
A VER is similar to a
quota except that the
exporter captures the
economic profit.
The Case Against Protection
Despite the fact that free trade promotes prosperity for all,
trade is often restricted.
It is often argued that international trade should be
restricted to
 Protect national security
 Protect infant industries
 Punish dumping
None of these arguments are convincing in the vast
majority of cases.
The Case Against Protection
Other fatally flawed arguments for protection are that it:
 Saves jobs
 Allows rich countries to compete with cheap foreign labor
 Penalizes nations with lax environmental standards
 Protects national culture
 Prevents rich nations from exploiting poor ones
The Case Against Protection
The National Security Argument
The national security argument is that a country must
protect domestic industries that make defense equipment
and armaments, and those industries that provide the raw
material necessary for defense production.
The argument is flawed for two reasons: (1) In time of war,
there is no industry that does not contribute to national
defense, so it is a plea for economic isolation. (2) It is less
inefficient to subsidize defense than to restrict trade with a
tariff.
The Case Against Protection
The Infant-Industry Argument
The infant-industry argument is that it is necessary to
protect a new industry from import competition to enable it
to grow into a mature industry that can compete in world
markets.
This argument is based on the concept of dynamic
competitive advantage, which can arise from learning-bydoing.
The Case Against Protection
Learning-by-doing is a powerful engine of productivity growth, but
this fact does not justify protection. If learning-by-doing would
lead to comparative advantage, producers should be willing to
invest in the learning to reap the later profits.
Government action is only needed to encourage learning-bydoing when its benefits spill over to other parts of the economy,
so those who invest in the learning cannot capture all the benefits
as later profits.
And even in this case, it is more efficient to subsidize an infant
industry than to protect it by restricting trade.
The Case Against Protection
The Dumping Argument
Dumping occurs when a foreign firm sells its exports at a lower
price than its cost of production.
Dumping is seen as a justification for a tariff to prevent a foreign firm
from driving domestic firms out of business and then raising its price.
This argument is flawed because: (1) It is very hard to determine a
firm’s costs; and (2) If there ever was a natural global monopoly, it
would be more efficient to regulate it than to impose a tariff against
it.
Note that both WTO and US law permit anti-dumping tariffs in
specific circumstances – but such cases are always controversial.
The Case Against Protection
Saves Jobs
The idea that buying foreign goods costs domestic jobs is
wrong.
Trade destroys some jobs, but creates other – usually
better -- jobs.
It also increases foreign incomes and enables foreigners
to buy more of what we produce.
Protection to save particular jobs is very costly.
The Case Against Protection
Allows rich countries to Compete with Cheap Foreign Labor
The idea that a high-wage country cannot compete with a lowwage country is wrong overall.
Low-wage labor is usually less productive than high-wage labor –
that is in part why it is low-wage.
The difference in production speed and quality is there. Because
of the demand for differentiated products and the existence of
high-end consumers especially in high-wage countries, highwage country is able to compete with low wage country.
The Case Against Protection
Penalizes Lax Environmental Standards
The idea that protection is necessarily good for the environment
is wrong. Higher environmental standards are definitely ‘normal
goods’, the demand for which rises with income.
Free trade increases incomes and poor countries tend to have
significantly lower environmental standards than rich countries.
These countries are likely to ‘buy’ a better environment as their
incomes rise.
The Case Against Protection
Protects National Culture
The idea that trade restrictions necessarily protect the national culture is
wrong.
This argument is not heard in the United States as much as it is heard in
Canada and European countries, and elsewhere.
Many countries are afraid of the “Americanization” of their culture through the
prominence of American films, television programs, art, literature, and even
cuisine in world markets.
Many countries, including the US, limit foreign ownership of radio and TV
stations. Foreign countries often limit imported programs on TV, and imports of
movies.
A culture, if it is strong enough, which most cultures are, can sustain. We can
see different cultures sustaining in harmony. Exposure to other cultures in fact
has the potential to enrich own culture.
The Case Against Protection
Prevents Rich Countries from Exploiting Poorer
Countries
The idea that trade restrictions prevent rich countries from
exploiting poorer countries is kind of silly.
Free trade is the best way of raising wages and improving
working conditions in poor countries.
The Case Against Protection
The most compelling argument against protection is that it
invites retaliation.
We saw retaliation to the Smoot-Hawley Act in the United
States during the Great Depression.
In a speech delivered on March 25, 2013, the formal FED
chair and prominent economist Ben Bernanke said:
“Economists still agree that Smoot-Hawley and the
ensuing tariff wars were highly counterproductive and
contributed to the depth and length of the global
Depression.”
Why Is International Trade Restricted?
The two key reasons why international trade is restricted
are
 Tariff revenue
 Rent seeking
Why Is International Trade Restricted?
Tariff Revenue
It is costly for governments to collect taxes on income and
domestic sales.
It is cheaper for governments to collect taxes on
international transactions because international trade is
carefully monitored.
This source of revenue is especially attractive to
governments in developing nations. In the 19th century it
was important in the US.
Why Is International Trade Restricted?
Rent Seeking
Rent seeking is lobbying and other political activities that seek to
capture the gains from trade. Free trade increases consumption
possibilities on the average, but not everyone shares in the gain
and some people even lose. Free trade brings benefits to some
and imposes costs on others, with total benefits exceeding total
costs. It is the uneven distribution of costs and benefits that is the
principal source of impediment to achieving more liberal
international trade.
Despite the fact that protection is inefficient, governments
respond to the demands of those who gain from protection and
ignore the interests of those who gain from free trade because
protection brings concentrated gains and diffused losses.
Why Is International Trade Restricted?
Compensating Losers
The gains from free trade exceed the losses, but the
losers typically are few and would lose a lot each, and
the gainers are often many, would gain little each, and
usually don’t know what protection costs them.
Sometimes free trade agreements address the issue of the
distribution of gains from trade by compensating those
who lose from free trade.