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CHAPTER 17 INTERNATIONAL TRADE In this chapter, you will find: Learning Outcomes Chapter Outline with PowerPoint Script Chapter Summary Teaching Points (as on Prep Card) Solutions to Problems Appendix Experiential Assignments INTRODUCTION The first half of this chapter considers comparative advantage and the gains from international trade. Once the gains from trade are discussed, the second half of the chapter examines trade restrictions, the welfare loss imposed on the economy, and the reasons for restrictions to persist. A theme of this chapter is that the beneficiaries of restrictions know that they are winners and that they are well organized, but those who bear the cost of restrictions—mainly domestic consumers—fail to recognize their losses and thus do not object. The asymmetry of gains and losses explains the resiliency of trade restrictions even though the economy as a whole would benefit from their elimination. LEARNING OUTCOMES 19-1 Outline the gains from trade, and explain why countries might still decide to trade even if no country has a comparative advantage. The law of comparative advantage says that the individual with the lowest opportunity cost of producing a particular good should specialize in that good. Just as individuals benefit from specialization and exchange, so do states and, indeed, nations. To reap the gains that arise from specialization, countries engage in international trade. Each country specializes in making goods with the lowest opportunity cost. Before countries can trade, however, they must agree on how much of one good exchanges for another (i.e., the terms of trade). 19-2 Explain how trade restrictions harm an economy, and why they persist. Market exchange usually generates a surplus, or a bonus, for both consumers and producers. Governments try to regulate surpluses by imposing tariffs (either specific or ad valorem) and import quotas, granting export subsidies, or extending low- interest loans to foreign buyers. Loss in U.S. consumer surplus resulting from tariffs is divided three ways: a portion goes to domestic producers; a portion becomes government revenue; and the last portion represents net losses in domestic social welfare. Welfare loss occurs when consumers must pay a higher price for products that could have been imported and sold at a lower price. 19-3 Identify international efforts to reduce trade barriers. Trade restrictions impose a variety of strains on the economy besides the higher costs to consumers, so countries have worked to create free trade agreements and common markets to reduce or eliminate trade barriers. The General Agreement on Tariffs and Trade (GATT) was an international treaty ratified in 1947 to reduce trade barriers. Subsequent negotiations lowered tariffs and reduced trade restrictions. The Uruguay Round, ratified in 1994, lowered tariffs, phased out quotas, and created the World Trade Organization (WTO) as the successor to GATT. © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Chapter 19 International Trade 258 19-4 Summarize five arguments often used to justify trade restrictions, and describe some unintended consequences of protecting certain industries from international competition. Arguments used by producer groups to support trade restrictions include promoting national defense, nurturing infant industries, preventing foreign producers from dumping goods in domestic markets, protecting domestic jobs, and allowing declining industries time to wind down and exit the market. Trade restrictions impose a variety of strains on the economy besides the higher costs to consumers. These include (1) the need to protect downstream stages of production as well, (2) expenditures made by favored domestic industries to seek and perpetuate trade protection, (3) costs incurred by the government to enforce trade restrictions, (4) the inefficiency and lack of innovation that result when an industry is insulated from foreign competition, and (5), most important, the trade restrictions imposed by other countries in retaliation. CHAPTER OUTLINE WITH POWERPOINT SCRIPT USE POWERPOINT SLIDES 2-5 FOR THE FOLLOWING SECTION The Gains from Trade: Each country specializes in making goods with the lowest opportunity cost. A Profile of Exports and Imports: U.S. exports of goods and services amounted to 14% of GDP in 2012. The largest category of exports is services which accounted for 29% of all U.S. exports. 47% come from capital goods and industrial supplies and materials. U.S. imports of goods and services were 17% of GDP in 2012. The three largest imports are industrial supplies and materials, consumer goods, and capital goods. USE POWERPOINT SLIDES 6-8 FOR THE FOLLOWING SECTION Production Possibilities Without Trade: Without international trade, a country’s production possibilities equal its consumption possibilities. USE POWERPOINT SLIDES 9-11 FOR THE FOLLOWING SECTION Consumption Possibilities Based on Comparative Advantage: According to the law of comparative advantage, each country should specialize in producing the good with the lower opportunity cost. Terms of trade: How much of one good exchanges for another good. USE POWERPOINT SLIDES 12-14 FOR THE FOLLOWING SECTION Reasons for International Specialization Differences in Resource Endowments: Countries export products they can produce more cheaply in return for products that are unavailable domestically or are cheaper elsewhere. Economies of Scale: Countries can gain from trade if the long-run average cost of production falls as the rate of production increases. Differences in Tastes: Different tastes across countries prompt trade. USE POWERPOINT SLIDES 15-23 FOR THE FOLLOWING SECTION Trade Restrictions and Welfare Loss Consumer Surplus and Producer Surplus from Market Exchange: Market exchange usually generates a surplus, or a bonus, for both consumers and producers. Tariffs: Taxes on imports—either specific, such as $5 per barrel of oil—or ad valorem—a percentage of the import price at the port of entry. World price: Determined by the world supply and demand for a product. Import Quotas: Legal limit on the amount of a commodity that can be imported. By limiting imports, the quota raises the domestic price above the world price and reduces quantity below the free-trade level. © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Chapter 19 International Trade 259 Quotas in Practice: By rewarding domestic and foreign producers with higher prices, the quota system creates two groups intent on securing and perpetuating these quotas. Tariffs and Quotas Compared: The primary difference between tariffs and quotas is the revenues. Revenues from tariffs go to the government; revenues from quotas go to whomever secures the right to sell foreign goods in U.S. markets. If quota rights accrue to foreigners, then the domestic economy is worse off with a quota than with a tariff. Other Trade Restrictions: Export subsidies, low-interest loans to foreign buyers, domestic content requirements restrict free trade. USE POWERPOINT SLIDES 24-25 FOR THE FOLLOWING SECTION Freer Trade by Multilateral Agreement General Agreement on Tariffs and Trade (GATT): An international trade treaty adopted in 1947 that resulted in a series of negotiated “rounds” aimed at freer trade. Dumping: Selling a commodity abroad for less than is charged in the home market or less than the cost of production. The World Trade Organization: (WTO) The legal and institutional foundation for world trade. USE POWERPOINT SLIDES 26-27 FOR THE FOLLOWING SECTION Common Markets: Free trade agreements among countries, such as the European Union and NAFTA. USE POWERPOINT SLIDES 28-31 FOR THE FOLLOWING SECTION Arguments for Trade Restrictions: These arguments support domestic producers but lead to a loss in social welfare. Some make more sense than others National Defense Argument: Protection from import competition because domestic output is vital for national defense. Infant Industry Argument: Protection for emerging domestic industries from foreign competition. Antidumping Argument: Foreign competitors should not be allowed to sell in this country for less than the cost of production or less than they charge in their home countries. Jobs and Income Argument: Restrictions protect domestic jobs and wage levels. Declining Industries Argument: Trade protection can help lessen shocks to the economy and allow for orderly transition to a new industrial mix. USE POWERPOINT SLIDE 32 FOR THE FOLLOWING SECTION Problems with Trade Protection: Protecting one stage of production may require protecting downstream stages. The cost of protection includes the resulting welfare loss AND the cost of resources used to seek protection. The transaction costs of enforcing the myriad restrictions. Economies isolated from foreign competition become less innovative and less efficient. Other countries usually retaliate. CHAPTER SUMMARY Even if a country has an absolute advantage in all goods, that country should specialize in producing the goods in which it has a comparative advantage. If each country specializes and trades according to the law of comparative advantage, all countries will have greater consumption possibilities. Quotas benefit those with the right to buy goods at the world price and sell them at the higher domestic price. Both tariffs and quotas harm domestic consumers more than they help domestic producers, although tariffs at least yield government revenue which can be used to fund valued public programs or to cut taxes. © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Chapter 19 International Trade 260 Despite the gains from free trade, trade restrictions have been imposed for centuries. The General Agreement on Tariffs and Trade (GATT) was an international treaty ratified in 1947 to reduce trade barriers. Subsequent negotiations lowered tariffs and reduced trade restrictions. The Uruguay Round, ratified in 1994, lowered tariffs, phased out quotas, and created the World Trade Organization (WTO) as the successor to GATT. The Doha Round was launched in 2001 but failed to reach an agreement as of 2011. Arguments used by producer groups to support trade restrictions include promoting national defense, nurturing infant industries, preventing foreign producers from dumping goods in domestic markets, protecting domestic jobs, and allowing declining industries time to wind down and exit the market. Trade restrictions impose a variety of strains on the economy besides the higher costs to consumers. These include (1) the need to protect downstream stages of production as well, (2) expenditures made by favored domestic industries to seek trade protection, (3) costs incurred by the government to enforce trade restrictions, (4) the inefficiency and lack of innovation that results when an industry is protected, and (5) most important, the trade restrictions imposed by other countries in retaliation. TEACHING POINTS 1. While this chapter contains potentially difficult material, most students are interested in international trade and the topic can lead to fruitful classroom discussion. 2. Although the principle of comparative advantage may have made sense to students when you discussed the importance of specialization and trade in the context of the production possibilities frontier, the emotional elements surrounding the discussion of trade and trade barriers may cause students to miss its relevance in the context of international trade. You should stress that the same principle applies and that students should think of a world production possibilities frontier. You will probably get into a discussion of the costs of free trade (or benefits of limiting trade), and therefore you must stress that the fact that each country realizes net gains from trade does not mean that everyone gains. After all, if the world price of a product (such as steel) is above the U.S. price, U.S. consumers lose when we export steel; therefore, the price for it rises in the United States. Students must become aware that goods consumption (not production) is the key to the standard of living. 3. The text discusses tariffs and quotas as well as their impacts. Exhibits 7 and 8 are very useful in illustrating these concepts. The principal difference between tariffs and quotas is that tariffs generate government revenue for the country imposing them, whereas quotas generate revenue for firms that are able to secure the licenses to import at the world price and sell at the higher domestic price. 4. Emphasize that trade restrictions impose a variety of strains on the economy besides the higher costs to consumers. These include (1) the need to protect downstream stages of production as well, (2) expenditures made by favored domestic industries to seek and perpetuate trade protection, (3) costs incurred by the government to enforce trade restrictions, (4) the inefficiency and lack of innovation that result when an industry is insulated from foreign competition, and (5), most important, the trade restrictions imposed by other countries in retaliation. © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Chapter 19 International Trade 261 SOLUTIONS TO PROBLEMS APPENDIX 1. (Trade Without Comparative Advantage) Even if neither country had a comparative advantage, why might these countries still experience gains from trade? Just as individuals benefit from specialization and exchange, so do states and, indeed, nations. To reap the gains that arise from specialization, countries engage in international trade. 2. (Comparative Advantage) Suppose that each U.S. worker can produce 8 units of food or 2 units of clothing daily. In Fredonia, which has the same number of workers, each worker can produce 7 units of food or 1 unit of clothing daily. Why does the United States have an absolute advantage in both goods? Which country enjoys a comparative advantage in food? Why? The United States has an absolute advantage because a single worker can produce more of both goods than can a single worker in Fredonia. Fredonia has a comparative advantage in food production because the opportunity cost of producing one more unit of food in Fredonia is equal to the cost of one-seventh of a unit of cloth, compared with a cost of one-fourth of a unit of cloth in the United States. 3. (Comparative Advantage) The consumption possibilities frontiers shown in the following exhibit [Exhibit 4] assume terms of trade of 1 unit of clothing for 1 unit of food. What would the consumption possibilities frontiers look like if the terms of trade were 1 unit of clothing for 2 units of food? As the “price” of clothing increases from 1 unit of food to 2 units of food, the U.S. consumption possibilities frontier shifts inward and the Izodian consumption possibilities frontier shifts outward. At 2 units of food per unit of clothing, which matches the U.S. opportunity cost, the U.S. consumption and production possibilities frontiers coincide! 4. (Reasons for International Specialization) What determines which goods a country should produce and export? One determinant of specialization is a country’s resource endowments. Countries with a relative abundance of skilled labor and sophisticated capital should specialize in hightechnology manufactured goods. Those with a relative abundance of unskilled or semiskilled labor should specialize in manufactured goods requiring less–skilled workers. Another important resource is land: A country should specialize in agricultural products for which its land and climate are most suited and in products for which it has an abundant supply of minerals. A second determinant is each country’s preferences. A country tends to import goods for which its residents have a high demand—exceeding its domestic capacity to produce the good efficiently. A country that can produce the good efficiently but has a relatively low demand for it would provide the imports. Economies of scale are another important determinant of specialization. A country with a large domestic market can develop large scales of operation for producing a good. The large scale can lead to lower average costs and create a comparative advantage in that good. © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Chapter 19 5. International Trade 262 (Import Quotas) How low must a quota be in effect to have an impact? Using a demand-andsupply diagram, illustrate and explain the net welfare loss from imposing such a quota. Under what circumstances would the net welfare loss from an import quota exceed the net welfare loss from an equivalent tariff (one that results in the same price and import level as the quota)? An effective import quota holds imports below the level that would occur with free trade. In the following graph S + q represents domestic supply (S) plus the quota. The horizontal distance between S and S + q equals the amount of the quota. With free trade, the price equals the world price Pw . The quota raises the price to Pq . At the higher price, the quantity consumed falls from D to C, and consumer surplus falls by areas a + b + c + d + e. However, the higher price encourages domestic production, and producer surplus rises by area a. Areas c + d represent the gains to those who have the quota rights to import quantity C – D. The minimum net welfare loss equals areas b + e which matches the net welfare loss of an equivalent tariff. However, to the extent that the profits from the quota rights (areas c + d) accrue to foreigners, the net welfare loss exceeds areas b + e (thus, exceeding the loss from an equivalent tariff). The government can generate revenues and reduce the net welfare loss to areas b + e by selling the quota rights. However, any rent-seeking activities of the quota by supporters would increase the losses. 6. (Trade Restrictions) Suppose that the world price for steel is below the U.S. domestic price, but the government requires that all steel used in the United States be domestically produced. a. Use a diagram like the one that follows to show the gains and losses from such a policy. b. How could you estimate the net welfare loss (deadweight loss) from such a diagram? c. What response to such a policy would you expect from industries (like automobile producers) that use U.S. steel? d. What government revenues are generated by this policy? © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Chapter 19 International Trade 263 a. Without restrictions Q* is consumed at a price of Pw , of which Q** is produced domestically and Q* – Q** is imported. With restrictions, the price rises to Pd o m , consumption drops to Qd o m , domestic production rises to Qd o m , and imports drop to zero. As a result, domestic producer surplus rises by Pw abPd o m , and consumer surplus falls by Pw cbPd o m . b. The net welfare loss equals triangle abc, the difference between the loss in consumer surplus and the gain in producer surplus. c. Gainers include the domestic manufacturers of steel, upstream firms that supply parts or other resources to the steel industry, firms that supply these upstream firms, and the employees of all these firms. Losers include other industries that use steel in their production (such as automobile producers), resource suppliers (including labor) to those industries, consumers who buy products made with steel, and taxpayers who underwrite the expense of policing and enforcing the restriction. Other losers are the foreign steel firms that are no longer able to export to the United States and their resource suppliers. If foreign prices drop because of increased supply as exports to the United States drop to zero, foreign consumers and their resource suppliers can gain. d. There are no government revenues. If the restriction is implemented through a prohibitive tariff, there are no tariff revenues since imports are zero. If the government uses quotas, all import quotas are set at zero so the government cannot sell quota rights. Given the cost of policing and enforcing the restriction, the government has a net loss. 7. (Trade Restrictions) The previous three graphs [Exhibits 7 and 8] show net losses to the economy of the country that imposes tariffs or quotas on imported sugar. What kinds of gains and losses would occur in the economies of countries that export sugar? By restricting world demand, tariffs or quotas on imported sugar lower the world price of sugar. This benefits consumers of sugar outside the United States and lowers producer surplus levels of sugar. However, because supply exceeds demand (in domestic terms) in those exporting countries, the loss of producer surplus exceeds the gain in consumer surplus and thus creates net losses in the exporting countries as well as in the importing country. © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Chapter 19 8. International Trade 264 (The World Trade Organization) What is the World Trade Organization (WTO) and how does it help foster multilateral trade? (Check the WTO website at http://www.wto.org/.) The World Trade Organization is the legal and institutional body for collective debate about international trade and restrictions among its more than 150 member countries. It provides trade policy analysis and assists in settling trade disputes among the members. The WTO was established as a result of the Uruguay Round of negotiations of the General Agreement on Tariffs and Trade (GATT). It became effective at the beginning of 1995 and replaced GATT. The most-favored-nation clause requires each member of the WTO to offer other member countries any trade concessions it negotiates with another member. Under the WTO, tariffs are legal but were to be reduced over a five-year period. Twenty-year patent protection is required in all member nations for almost all fields of technology. However, quotas are generally outlawed (and are to be phased out over a ten-year period). Dumping and export subsidies are considered unfair. 9. (Arguments for Trade Restrictions) Explain the national defense, declining industries, and infant industry arguments for protecting a domestic industry from international competition. The national defense argument claims that certain industries need protection because their output is necessary during war. Military considerations require the existence of a domestic producer of the good regardless of economic considerations. The declining industries argument calls for temporary protection to allow the orderly adjustment of a domestic industry that is in jeopardy of being replaced by lower-priced imports. The temporary restriction of imports is designed to lessen the shock to the domestic economy while the industry is phased out. The infant industry argument advocates protecting a newly emerging domestic industry until it becomes efficient enough to compete effectively with foreign producers without protection. The restrictions are seen as temporary until the domestic industry can develop sufficient economies of scale. 10. (Arguments for Trade Restrictions) Firms hurt by cheap imports typically argue that restricting trade will save U.S. jobs. What’s wrong with this argument? Are there ever any reasons to support such trade restrictions? The chief problems with this argument are that jobs saved by import protection are likely to be offset by jobs lost in export industries as other nations retaliate and the fact that potential gains from trade are not realized. Furthermore, by saving jobs in industries for which we do not have a comparative advantage, we drive up the cost of consumer goods in this country and slow the structural shifts in the world economy that are necessary to allocate world resources efficiently. Only if an industry were so vital to U.S. interests to deem foreign trade dependency “too dangerous” would such an argument ever make sense. Experiential Exercises 1. Send your students to the Office of the U.S. Trade Representative at http://www.ustr.gov/. The U.S. Trade Representative is a cabinet member who acts as the principal trade advisor, negotiator, and spokesperson for the president on trade and related investment matters. Have them read some of © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Chapter 19 International Trade 265 the most recent press releases. What are some of the trade-related issues the United States is currently facing? 2. The Wall Street Journal is one of the world’s best sources of information regarding international trade—the International page is inside the first section of each day’s edition. Ask students to find an article in today’s issue (or some recent issue) dealing with trade barriers—tariffs, quotas, and so on. If the article provides sufficient information to estimate costs and benefits in dollar terms, have them model the trade barrier using a graph, and determine who benefits and who bears the costs. © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.