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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.
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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.
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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
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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.
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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.
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(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?
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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.
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(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
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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.