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© 2007 Thomson South-Western
Application: International Trade
• What determines whether a country imports or
exports a good?
• Who gains and who loses
from free trade among
countries?
• What are the arguments that
people use to advocate trade
restrictions?
© 2007 Thomson South-Western
THE DETERMINANTS OF TRADE
• Equilibrium Without Trade
– Assume:
• A country is isolated from rest of the world and
produces steel.
• The market for steel consists of the buyers and sellers in
the country.
• No one in the country is allowed to import or export
steel.
© 2007 Thomson South-Western
Figure 1 The Equilibrium without International Trade
Price
of Steel
Domestic
supply
Consumer
surplus
Equilibrium
price
Producer
surplus
Domestic
demand
0
Equilibrium
quantity
Quantity
of Steel
© 2007 Thomson South-Western
The Equilibrium Without Trade
• Results:
• Domestic price adjusts to balance demand and
supply.
• The sum of consumer and producer surplus
measures the total benefits that buyers and sellers
receive.
© 2007 Thomson South-Western
The World Price and Comparative
Advantage
• If the country decides to engage in international
trade, will it be an importer or exporter of steel?
© 2007 Thomson South-Western
The World Price and Comparative
Advantage
• The effects of free trade can be shown by
comparing the domestic price of a good without
trade and the world price of the good. The
world price refers to the price that prevails in
the world market for that good.
© 2007 Thomson South-Western
The World Price and Comparative
Advantage
• If a country has a comparative advantage, then
• the domestic price will be below the world price,
and
• the country will be an exporter of the good.
• If the country does not have a comparative
advantage, then
• the domestic price will be higher than the world
price, and
• the country will be an importer of the good.
© 2007 Thomson South-Western
Figure 2 International Trade in an Exporting Country
Price
of Steel
Domestic
supply
Price
after
trade
World
price
Price
before
trade
Exports
0
Domestic
quantity
demanded
Domestic
demand
Domestic
quantity
supplied
Quantity
of Steel
© 2007 Thomson South-Western
Figure 2 International Trade in an Exporting Country
Price
of Steel
Price
after
trade
Domestic
supply
Exports
A
B
Price
before
trade
World
price
D
C
Domestic
demand
0
Quantity
of Steel
© 2007 Thomson South-Western
Figure 2 International Trade in an Exporting Country
Price
of Steel
Price
after
trade
Consumer surplus
surplus
Consumer
after trade
before
trade
Exports
A
BB
Price
before
trade
World
price
D
C
C
Producer surplus
after
before
trade
trade
0
Domestic
supply
Domestic
demand
Quantity
of Steel
© 2007 Thomson South-Western
How Free Trade Affects Welfare in an Exporting Country
© 2007 Thomson South-Western
THE WINNERS AND LOSERS
FROM TRADE
• The analysis of an exporting country yields
two conclusions:
– Domestic producers of the good are better off, and
domestic consumers of the good are worse off.
– Trade raises the economic well-being of the nation
as a whole.
© 2007 Thomson South-Western
The Gains and Losses of an Importing
Country
• International Trade in an Importing Country
• If the world price of steel is lower than the domestic
price,
• the country will be an importer of steel when trade is
permitted.
• domestic consumers will want to buy steel at the lower
world price.
• domestic producers of steel will have to lower their
output because the domestic price moves to the world
price.
© 2007 Thomson South-Western
Figure 3 International Trade in an Importing Country
Price
of Steel
Domestic
supply
Price
before
trade
Price
after
trade
World
price
Imports
0
Domestic
quantity
supplied
Domestic
quantity
demanded
Domestic
demand
Quantity
of Steel
© 2007 Thomson South-Western
Figure 3 International Trade in an Importing Country
Price
of Steel
Consumer surplus
before trade
Domestic
supply
A
Price
before trade
Price
after trade
B
C
D
Imports
Producer surplus
before trade
0
World
price
Domestic
demand
Quantity
of Steel
© 2007 Thomson South-Western
Figure 3 International Trade in an Importing Country
Price
of Steel
Consumer surplus
after trade
Domestic
supply
A
Price
before trade
Price
after trade
0
BB
C
D
Imports
Producer surplus
after trade
World
price
Domestic
demand
Quantity
of Steel
© 2007 Thomson South-Western
How Free Trade Affects Welfare in an Importing Country
© 2007 Thomson South-Western
The Gains and Losses of an Importing
Country
• How Free Trade Affects Welfare in an
Importing Country
• The analysis of an importing country yields two
conclusions:
• Domestic producers of the good are worse off, and
domestic consumers of the good are better off.
• Trade raises the economic well-being of the nation as a
whole because the gains of consumers exceed the losses
of producers.
© 2007 Thomson South-Western
THE WINNERS AND LOSERS
FROM TRADE
• The gains of the winners exceed the losses of
the losers.
• The net change in total
surplus is positive.
© 2007 Thomson South-Western
The Effects of a Tariff
• A tariff is a tax on goods produced abroad and
sold domestically.
• Tariffs raise the price of imported goods above
the world price by the amount of the tariff.
© 2007 Thomson South-Western
Figure 4 The Effects of a Tariff
Price
of Steel
Domestic
supply
Equilibrium
without trade
Price
with tariff
Tariff
Price
without tariff
0
Imports
with tariff
S
Q
S
Domestic
demand
D
Q
Q
Imports
without tariff
D
Q
World
price
Quantity
of Steel
© 2007 Thomson South-Western
Figure 4 The Effects of a Tariff
Price
of Steel
Consumer surplus
before tariff
Producer
surplus
before tariff
Domestic
supply
Equilibrium
without trade
Price
without tariff
0
Domestic
demand
S
D
Q
Q
Imports
without tariff
World
price
Quantity
of Steel
© 2007 Thomson South-Western
Figure 4 The Effects of a Tariff
Price
of Steel
Consumer surplus
after tariff
A
Domestic
supply
Equilibrium
without trade
B
Price
with tariff
Tariff
Price
without tariff
0
Imports
with tariff
S
Q
S
Domestic
demand
D
Q
Q
Imports
without tariff
D
Q
World
price
Quantity
of Steel
© 2007 Thomson South-Western
Figure 4 The Effects of a Tariff
Price
of Steel
Domestic
supply
Producer
surplus
after tariff
Price
with tariff
Equilibrium
without trade
Tariff
C
Price
without tariff G
0
Imports
with tariff
S
Q
S
Domestic
demand
D
Q
Q
Imports
without tariff
D
Q
World
price
Quantity
of Steel
© 2007 Thomson South-Western
Figure 4 The Effects of a Tariff
Price
of Steel
Domestic
supply
Tariff Revenue
Price
with tariff
Tariff
E
Price
without tariff
0
Imports
with tariff
S
Q
S
Domestic
demand
D
Q
Q
Imports
without tariff
D
Q
World
price
Quantity
of Steel
© 2007 Thomson South-Western
Figure 4 The Effects of a Tariff
Price
of Steel
Consumer surplus
Producer surplus
Domestic
supply
A
Deadweight Loss
B
Price
with tariff
Tariff
C
D
Price
without tariff G
0
E
F
Imports
with tariff
S
Q
S
Domestic
demand
D
Q
Q
Imports
without tariff
D
Q
World
price
Quantity
of Steel
© 2007 Thomson South-Western
The Effects of a Tariff
© 2007 Thomson South-Western
ACTIVE LEAR N I N G 1
Analysis of trade
Without trade,
PD = $3000, Q = 400
P
Plasma TVs
S
In world markets,
PW = $1500
Under free trade, $3000
how many TVs
will the country
$1500
import or export?
Identify CS, PS, and
total surplus without
trade, and with trade.
D
200
400
600
Q
28
© 2007 Thomson South-Western
ACTIVE LEAR N I N G 1
Answers
Under free
trade,
– domestic
consumers
demand 600
– domestic
producers
supply 200
– imports = 400
P
Plasma TVs
S
$3000
$1500
D
imports
200
600
Q
29
© 2007 Thomson South-Western
ACTIVE LEAR N I N G 1
Answers
Without trade,
CS = A
PS = B + C
Total surplus
=A+B+C
P
Plasma TVs
S
gains
from trade
A
$3000
With trade,
CS = A + B + D $1500 C
PS = C
Total surplus
=A+B+C+D
B
D
imports
D
Q
30
© 2007 Thomson South-Western
The Effects of a Tariff
• A tariff reduces the quantity of imports and
moves the domestic market closer to its
equilibrium without trade.
• With a tariff, total surplus in the market
decreases by an amount referred to as a
deadweight loss.
© 2007 Thomson South-Western
Tariff: An Example of a Trade Restriction
• Tariff: a tax on imports
• Example: Cotton shirts
PW = $20
Tariff: T = $10/shirt
Consumers must pay $30 for an imported shirt.
So, domestic producers can charge $30 per shirt.
• In general, the price facing domestic buyers &
sellers equals (PW + T ).
© 2007 Thomson South-Western
Analysis of a Tariff on Cotton Shirts
P
PW = $20
Free trade:
Cotton shirts
buyers demand 80
sellers supply 25
imports = 55
S
T = $10/shirt
price rises to $30
buyers demand 70
sellers supply 40
imports = 30
$30
$20
imports
imports
25
40
70 80
D
Q
© 2007 Thomson South-Western
Analysis of a Tariff on Cotton Shirts
P
Free trade
Cotton
shirts
deadweight
loss = D + F
CS = A + B + C
+D+E+F
PS = G
Total surplus = A + B
+C+D+E+F+G
Tariff
CS = A + B
PS = C + G
Revenue = E
Total surplus = A + B
+C+E+G
S
A
B
$30
$20
C
D
E
F
G
25
40
70 80
D
Q
© 2007 Thomson South-Western
Analysis of a Tariff on Cotton Shirts
P
Cotton
shirts
deadweight
loss = D + F
D = deadweight loss
from the
overproduction
of shirts
A
F = deadweight loss
from the under$30
consumption
C
D
$20
of shirts
G
25
40
S
B
E
F
70 80
D
Q
© 2007 Thomson South-Western
FYI: Import Quotas: Another Way to
Restrict Trade
• The Effects of an Import Quota
• An import quota is a limit on the quantity of a good
that can be produced abroad and sold domestically.
• Because the quota raises the domestic price above
the world price, domestic buyers of the good are
worse off, and domestic sellers of the good are
better off.
• License holders are better off because they make a
profit from buying at the world price and selling at
the higher domestic price.
© 2007 Thomson South-Western
The Effects of an Import Quota
Price
of Steel
Firms with licenses to
import, will supply more.
The quantity of imports is exactly
the same as the horizontal shift in
the supply curve.
The Supply curve shifts
horizontally by the amount
of the licensed imports.
Domestic
supply
Equilibrium
without trade
Quota
Isolandian
price with
quota
Equilibrium
with quota
Price
World
without =
price
quota
0
Domestic
supply
+
Import supply
Imports
with quota
S
Q
S
Domestic
demand
D
Q
Q
Imports
without quota
D
Q
World
price
Quantity
of Steel
© 2007 Thomson South-Western
The Effects of an Import Quota
Price
of Steel
Consumer surplus after quota
Surplus for firms
with licenses
Domestic
supply
Equilibrium
without trade
Quota
A
Isolandian
price with
quota
Price
World
without =
price G
quota
0
Producer surplus
after quota
B
C
E'
D
Equilibrium
with quota
F
E"
Imports
with quota
S
Q
Domestic
supply
+
Import supply
S
Domestic
demand
D
Q
Q
Imports
without quota
D
Q
World
price
Quantity
of Steel
© 2007 Thomson South-Western
The Effects of an Import Quota
© 2007 Thomson South-Western
FYI: Import Quotas: Another Way to
Restrict Trade
• With a quota, total surplus in the market
decreases by an amount referred to as a
deadweight loss.
• The quota can potentially cause an even larger
deadweight loss, if a mechanism such as
lobbying is employed to allocate the import
licenses.
© 2007 Thomson South-Western
The Lessons for Trade Policy
• If government sells import licenses for full
value, revenue equals that of an equivalent tariff
and the results of tariffs and quotas are
identical.
© 2007 Thomson South-Western
The Lessons for Trade Policy
• Both tariffs and import quotas . . .
•
•
•
•
raise domestic prices.
reduce the welfare of domestic consumers.
increase the welfare of domestic producers.
cause deadweight losses.
© 2007 Thomson South-Western
The Lessons for Trade Policy
• Other Benefits of International Trade
•
•
•
•
Increased variety of goods
Lower costs through economies of scale
Increased competition
Enhanced flow of ideas
© 2007 Thomson South-Western
THE ARGUMENTS FOR RESTRICTING
TRADE
•
•
•
•
•
Jobs Argument
National-Security Argument
Infant-Industry Argument
Unfair-Competition Argument
Protection-as-a-Bargaining-Chip Argument
© 2007 Thomson South-Western
Arguments for Restricting Trade
1. The jobs argument
Trade destroys jobs in industries that compete with
imports.
Economists’ response:
Look at the data to see whether rising imports cause
rising unemployment…
© 2007 Thomson South-Western
U.S. Imports & Unemployment,
Decade averages, 1956-2005
16%
Imports
(% of GDP)
14%
12%
10%
8%
Unemployment
(% of labor force)
6%
4%
2%
1996
-2005
1986
-95
1976
-85
1966
-75
1956
-65
0%
© 2007 Thomson South-Western
Arguments for Restricting Trade
1. The jobs argument
Trade destroys jobs in the industries that compete
against imports.
Economists’ response:
Total unemployment does not rise as imports rise,
because job losses from imports are offset by
job gains in export industries.
Even if all goods could be produced more cheaply
abroad, the country need only have a
comparative advantage to have a viable export
industry and to gain from trade.
© 2007 Thomson South-Western
Arguments for Restricting Trade
2. The national security argument
An industry vital to national security should be
protected from foreign competition, to prevent
dependence on imports that could be disrupted
during wartime.
Economists’ response:
Fine, as long as we base policy on true security
needs.
But producers may exaggerate their own importance
to national security to obtain protection from foreign
competition.
© 2007 Thomson South-Western
Arguments for Restricting Trade
3. The infant-industry argument
A new industry argues for temporary protection until
it is mature and can compete with foreign firms.
Economists’ response:
Difficult for govt to determine which industries
will eventually be able to compete and whether
benefits of establishing these industries exceed cost
to consumers of restricting imports.
Besides, if a firm will be profitable in the long run,
it should be willing to incur temporary losses.
© 2007 Thomson South-Western
Arguments for Restricting Trade
4. The unfair-competition argument
Producers argue their competitors in another country
have an unfair advantage,
e.g. due to govt subsidies.
Economists’ response:
Great! Then we can import extra-cheap products
subsidized by the other country’s taxpayers.
The gains to our consumers will exceed the losses to
our producers.
© 2007 Thomson South-Western
Arguments for Restricting Trade
5. The protection-as-bargaining-chip
argument
Example: The U.S. can threaten to limit imports
of French wine unless France lifts their quotas
on American beef.
Economists’ response:
Suppose France refuses. Then the U.S. must choose
between two bad options:
A) Restrict imports from France, which reduces
welfare in the U.S.
B) Don’t restrict imports, which reduces U.S.
credibility.
© 2007 Thomson South-Western
Trade Agreements
• A country can liberalize trade with
• unilateral reductions in trade restrictions
• multilateral agreements with other nations
• Examples of trade agreements:
• North American Free Trade Agreement (NAFTA),
1993
• General Agreement on Tariffs and Trade (GATT),
ongoing
• World Trade Organization (WTO), est. 1995,
enforces trade agreements, resolves disputes
© 2007 Thomson South-Western
CASE STUDY: KORUS FTA
• Opening up the Korean Beef Market to
US Imports (for approx. the same qty and quality meat)
• Korean Beef Price at Lotte Mart = 31,500/kilo
• Aust. Beef Price at Lotte Mart = 21,000/kilo
© 2007 Thomson South-Western
CASE STUDY: KORUS FTA
• Opening up the Korean Beef Market to USA
Imports (for approx. the same qty and quality meat)
• Safeway (US grocery store chain) retail price in Seattle,
WA (doesn’t account for shipping and any added expenses) =
7,500/kilo
© 2007 Thomson South-Western
CASE STUDY: KORUS FTA
•
•
•
•
305,000 metric tons consumed (2006)
Total Spending (only Korean Beef): 19.2 Quad.
Total Spending (only Austr. Beef): 12.8 Quad.
Total Spending (only US Beef):
4.58 Quad.
• (Approx. spending assuming above assumptions and US
Beef xfer pricing similar to what is found in USA)
• What is the Korean consumer surplus?
• What is Korean producer surplus?
© 2007 Thomson South-Western
Summary
• The effects of free trade can be determined by
comparing the domestic price without trade to
the world price.
– A low domestic price indicates that the country has
a comparative advantage in producing the good
and that the country will become an exporter.
– A high domestic price indicates that the rest of the
world has a comparative advantage in producing
the good and that the country will become an
importer.
© 2007 Thomson South-Western
Summary
• When a country allows trade and becomes an
exporter of a good, producers of the good are
better off, and consumers of the good are
worse off.
• When a country allows trade and becomes an
importer of a good, consumers of the good are
better off, and producers are worse off.
© 2007 Thomson South-Western
Summary
• A tariff—a tax on imports—moves a market
closer to the equilibrium that would exist
without trade, and therefore reduces the gains
from trade.
• Import quotas will have effects similar to those
of tariffs.
© 2007 Thomson South-Western
Summary
• There are various arguments for restricting
trade: protecting jobs, defending national
security, helping infant industries, preventing
unfair competition, and responding to foreign
trade restrictions.
• Economists, however, believe that free trade is
usually the better policy.
© 2007 Thomson South-Western