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Chapter 19
International Trade
© 2006 Thomson/South-Western
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Profile of Imports and Exports
U.S. exports of goods and services
amounted to about 10% of GDP in
2003
U.S. imports of goods and services
were 14% relative to GDP in 2003
Raw materials
Oil and metals major imports
Agricultural products major exports
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Profile of Imports and Exports
Canada, Mexico, Japan, Great
Britain, and Germany are major
importers of U.S. goods/services
Canada, China, Mexico, Japan, and
Germany are major exporters of
goods/services to U.S.
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Exhibit 1: Composition of U.S.
Merchandise Exports
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Exhibit 1: Composition of U.S.
Merchandise Imports
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Exhibit 2: U.S. Production as a
Percentage of U.S. Consumption
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Exhibit 3: Production Possibilities
The U.S. has an absolute advantage, can produce more of both with fewer resources
than other producers require
But following the law of comparative advantage, the U.S. is the low cost producer, with
a comparative advantage in the production of clothing, while Izodia has a comparative
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advantage in the production of food
Exhibit 4: Production Possibilities Without
Trade
Autarkey
equilibrium
Autarkey
equilibrium
•Exhibit 4 illustrates the possible combinations of food and clothing that each country
can produce and consume if all resources are fully and efficiently employed and there
is no trade: Autarky is the situation of national self-sufficiency.
•The fact that both PPFs are straight lines implies a constant opportunity cost.
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Terms of Trade
Before the countries can trade, the terms of
trade must be established
Terms of trade refers to how much of one good
exchanges for a unit of another good
Suppose that market forces dictate that 1 unit
of food trades for 1 unit of clothing
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Exhibit 5: Production (and Consumption) Possibilities
Frontiers with Trade
U.S. preferred
combination
Izodian preferred
combination
The U.S. consumption possibilities frontier stops at 400 million units of clothing because that is the
most that Izodians can produce
With production and specialization, the U.S. produces 600 units of food, consumes 400 units, and
exchanges the rest for 200 million units of Izodian clothing.
Izodians produce 400 units of clothing, wear 200 million units, and exchange the rest for 200 million
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units of U.S. food
Summary
The only constraint on trade is that, for
each good, total world production must
equal total world consumption
Specialization and trade allow both
countries to consume more of both goods
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Reasons for International Specialization
Differences in Resource Endowments
Economies of Scale
Differences in Tastes
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Tariffs
Tariff: a tax on imports and can be either
specific or ad valorem
Specific tariff is a fixed fee amount, for
example a tariff of $5 per barrel of oil
Ad valorem tariff is a percentage of the price
of imports at the point of entry
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Exhibit 6: Effect of a Tariff
Consumers’ loss of
surplus is the sum of
areas a, b, c, and d.
Area a represents an
increase in producer
surplus.
Area b is a net U.S.
welfare loss.
Area c shows
government revenue from
the tariff.
Area d reflects the loss
of consumer surplus
resulting from the drop in
consumption.
The net welfare loss to
the U.S. economy consists
of areas b and d.
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Import Quotas
Import quota: a legal limit on the quantity of a
particular commodity that can be imported
Usually target imports from certain countries
To have an impact on the domestic market, or
to be effective, a quota must restrict imports to
less than the amount imported with free trade
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Exhibit 7: Effect of a Quota
After the quota, the new U.S. price, $0.15 per
pound, is determined by the intersection of
the new supply curve, S', with the U.S.
demand curve, D.
The blue shaded areas show the loss in
consumer surplus captured by domestic
producers and those permitted to fulfill the
quota.
The pink-shaded triangles illustrate the net
welfare cost of the quota on the U.S. economy.
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Exhibit 7: Effect of a Quota
•Area a represents a transfer
from U.S. consumers to U.S.
producers.
•Triangular area b reflects a
net loss - the amount by which
the cost of producing an extra
10 million pounds of sugar in
the United States exceeds the
cost of buying it from abroad.
•Rectangular area c shows the
gain to those who can sell
foreign-grown sugar at the
higher U.S. price instead of
the world price.
•Area d also reflects a net
loss—a reduction in consumer
surplus as consumption falls
because of the price increase.
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Quotas in Practice
Quota rights are awarded to exporters
through a variety of means
By rewarding domestic producers with
higher prices and foreign producers with
the right to sell goods to the United
States, the quota system creates two
groups intent on securing and
perpetuating these quotas
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Tariffs and Quotas Compared
 Since the tariff and the quota in our example had
identical effects on the price, they reflect the same
change in quantity demanded
 U.S. consumers suffer the same loss of consumer
surplus and U.S. producers reap the same gain of
consumer surplus
 The primary difference: the revenue from the
tariff goes to the domestic government, whereas the
revenue from the quota goes to whoever secures the
right to sell foreign goods in the U.S. market
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Tariffs and Quotas Compared
If quota rights accrue to foreigners, then the
domestic economy is worse off with a quota
than with a tariff
Even if quota rights go to domestic
importers, quotas, like tariffs, still increase
the domestic price, restrict quantity and
reduce consumer surplus
Quotas and tariffs also encourage foreign
governments to retaliate with quotas and
tariffs of their own
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Other Trade Restrictions
Export subsidies: encourage firms to export
Low-interest loans to foreign buyers: promote
exports of large capital goods
Domestic content requirements: specify that a
certain percentage of a final good’s value must
be produced domestically
Other requirements concerning health, safety, or
technical standards: often discriminate against
foreign goods
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GATT
 General Agreement on Tariffs and Trade – GATT –
an international tariff-reduction treaty adopted in
1947 that resulted in a series of negotiated “rounds”
aimed at freer trade
 Adopted by 23 countries, including the United States
 Treat all member nations equally with respect to trade
 Reduce tariff rates through multinational negotiations
 Reduce import quotas
 Set the stage of many trade rounds which offer a package
approach rather than an issue-by-issue approach to trade
negotiations
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Trading Rounds
Most early GATT trade rounds aimed at
reducing tariffs
The Kennedy Round in the mid-1960s
included new provisions against dumping
Recent Uruguay round created the World
Trade Organization to take over from
GATT
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The World Trade Organization
Permanent institution located in Geneva,
Switzerland
Includes services and trade-related aspects of
intellectual property, such as books, movies, and
computer programs
Under the most-favored-nation clause, each WTO
member must offer all other member countries the
same trade concessions offered to any member country
Average tariffs will fall from 6% to 4%
Includes a dispute settlement body that should be
faster, more automatic, and less susceptible to
blockage than GATT
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Common Markets
European Union.
Began in 1958 and now has expanded to 25
nations
Intended to create a barrier-free European
market in which goods, services, people, and
capital are free to flow to their highest-valued
use without restrictions
Twelve members of the European Union have
adopted a common currency, the euro, that
replaced national currencies in January 2002
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Common Markets
Other trading blocs
The Association of Southeast Asian nations: ASEAN
South Africa and its four neighboring countries:
Southern African Customs Union
Half dozen Latin American countries: Mercosur
United States, Canada, and Mexico: NAFTA
Mexico hopes to increase U.S. investment by guaranteeing dutyfree access to U.S. markets to those who build manufacturing
plants in Mexico
The U.S. wants access to Mexico’s 100 million people and its
huge oil reserves
U.S. would like to bolster Mexico’s move toward a marketoriented economy
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National Defense Argument
 Industries are said to be in need of protection from
import competition because their production is
vital in time of war  protection is in the national
interest
 Trade restrictions may shelter the defense industry,
but other methods, might be more efficient
 Government subsidies
 Government could stockpile basic military hardware so
that maintaining an ongoing productive capacity would
become less essential
 Problem with this argument is that most industries
can make this same argument
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Infant Industry Argument
Rationale here is to protect emerging domestic
industries from foreign competition
In industries where a firm’s average cost per unit
falls as production expands, new domestic firms
may need protection from foreign competitors until
they reach sufficient size to achieve sufficient
economies of scale
How should government identify which
industries merit protection, and when do they
become old enough to look out for themselves?
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Infant Industry Argument
The very existence of protection may foster
inefficiencies that firms may not be able to
outgrow
The immediate cost of such restrictions is the
net welfare loss from higher domestic prices
Which may become permanent if the industry
never realizes the expected economies of scale
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Antidumping Argument
Dumping is selling a commodity abroad at a
price that is below its cost of production or
below the price charged in the home market 
critics argue that a tariff should be imposed to
raise the price of dumped goods
Key question: Why should U.S. consumers be
prevented from buying products for as little as
possible even if these low prices are the result of
a foreign subsidy?
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Antidumping Argument
If the dumping is persistent, the lower price
may increase consumer surplus by an amount
that more than offsets losses to domestic
producers  there is no good reason why
consumers should not be allowed to buy
imports for a persistently low price
An alternative form of dumping, termed
predatory dumping, is the temporary sale of an
export at a lower price in order to drive out
competing producers in that foreign market
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Jobs and Income Argument
One of the more common arguments is that
they protect U.S. jobs and wage levels
Problem: other countries will likely retaliate by
restricting their imports to save their jobs with
the net result that international trade is
reduced
Wage rates in other countries, especially developing
countries, are often a small fraction of wages in the
U.S.
Wages represent just one component of the total
production cost and may not necessarily be the most
important
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Jobs and Income Argument
What is important is not wage rates per se,
rather it is the labor cost per unit of output
which depend on both the wage rate and labor
productivity
Wage rates are high in the United States partly
because labor productivity remains the highest
in the world
Conversely, lower wages in many competing
countries can be partially traced to workers’ lack of
education and training, the meager amount of
physical capital available to each worker, and a
business climate that is less stable and less attractive
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Declining Industries Argument
Where an established domestic industry is in
jeopardy of being displaced by lower-priced
imports, there could be a rationale for
temporary import restrictions to allow the
orderly adjustment of the domestic industry
This is particularly true when there are many
industry-specific resources
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Declining Industries Argument
The protection offered should not be so
generous as to encourage investment in the
industry
Free trade may displace some U.S. jobs
through imports, but it also creates U.S. jobs
through exports
Where foreign competition appears to have
displaced U.S. workers, many foreign
companies have built plants in the United
States and employ U.S. workers
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Problems with Protection
Protecting one state of production often
requires protecting downstream stages of
production
The cost of protection includes not only the
welfare loss arising from the higher domestic
price, but also the cost of the resources used by
domestic producers and groups to secure the
favored protection  the cost of this rent
seeking – lobbying fees, propaganda, legal
actions – can equal or exceed the direct welfare
loss from the restrictions
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Problems with Protection
A third problem with imposing trade
restrictions is that other countries often
retaliate, thus further reducing the gains from
trade
A final problem with trade restrictions is the
costs of enforcing the myriad quotas, tariffs,
and other restrictions
Also run into the practice of “port shopping”
where foreign producers and U.S. importers
shop to see where inspections are most lax
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Import Substitution
The country manufactures products that until
then had been imported and imposes tariffs
and quotas to protect these industries
Popular for several reasons
Demand already existed for these products
Provides infant industries with a protected market
Those who already supply capital, labor and other
resources to the favored industries gain
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Import Substitution
Problems
Reduces the gains from specialization and
comparative advantage
Low-cost foreign goods with high-cost domestic
goods
Since they are shielded from foreign competition,
domestic industries fail to become efficient
Encourages retaliation from other countries
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Export Promotion
A development strategy that concentrates on
producing for the export market
Preferable approach because the emphasis is on
comparative advantage and trade expansion
rather than trade restriction
Also forces producers to grow more efficient to
compete on world markets
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