CHAPTER 19: International Trade CHAPTER 19: International Trade

CHAPTER 19:

International Trade

CHAPTER 19:

International Trade

CHAPTER CHECKLIST

1. Describe patterns and trends in international trade.

2. Explain why nations engage in international trade and why trade benefits all nations.

3. Explain how trade barriers reduce international trade.

4. Explain the arguments used to justify trade barriers and show why they are incorrect but also why some barriers are hard to remove.

LECTURE TOPICS

Trade Patterns and Trends

The Gains from International Trade

International Trade Restrictions

The Case Against Protection

LECTURE TOPICS

19.1 TRADE PATTERNS AND TRENDS

Imports are the goods and services that we buy from people and firms in other countries.

Exports are the goods and services that we sell to people, firms, and governments in other countries.

We trade internationally:• Goods • Services


Trade in GoodsManufactured goods account for:

50 percent of U.S. Exports

60 percent of U.S. imports

Industrial materials account for:

17 percent of U.S. exports


Agricultural products account for:




Trade in ServicesU.S. international trade in services is large and growing.

Services account for:



Services include hotel and transportation services bought by American tourists abroad and foreign tourists in the United States, insurance, transport and banking services, and fees and income from films, music, software, books, patents and industrial know-how, accounting and consulting firms, etc.


Trends in the Volume of TradeIn 1960, the United States:

Exported 5 percent of total output [GDP]

Imported 5 percent of the goods and services bought.

In 1998, the United States:

Exported 11 percent of total output [GDP]

Imported 13 percent of the goods and services bought.


Trading Partners and Trading Blocs

The United States has trading links with every part of the world.

The United States is a member of several international organizations that seek to promote international trade and regional trade.


U.S. Trading Partners

Biggest trading partner: Canada

Second biggest trading partners: Mexico and Japan

Other large trading partners:• China• Germany• United Kingdom

Significant volumes of trade with:• Hong Kong, South Korea, and Taiwan


Trading Blocs

A trading bloc is a group of nations in an international organization.

The three largest geographical trading blocs are:• North American Free Trade Agreement• Asia-Pacific Economic Cooperation• European Union


North American Free Trade Agreement (NAFTA)

An agreement between the United States, Canada, and Mexico to make trade among them easier and freer.

NAFTA came into effect in 1994 and since then trade among these three countries has grown rapidly.

All American countries, except Cuba, have entered into a Free Trade of the Americas process, which aims for free trade among all American nations by 2005.


Asia-Pacific Economic Cooperation (APEC)

APEC is a group of 21 nations that border the Pacific Ocean.

APEC was established in 1989 and has developed into an organization that promotes freer trade and cooperation among its members.

In 1999, APEC nations conducted 44 percent of world international trade.


Balance of Trade and International Borrowing

Balance of tradeThe value of exports minus the value of imports.

In 2000, U.S. imports exceeded U.S. exports and the U.S. trade balance was negative.


A country has a:• Trade deficit if imports > exports.• Trade surplus if exports > imports.

When a country has a trade deficit, it pays for the deficit by borrowing from other countries or by selling net some of its assets [either at home or abroad].

When a country has a trade surplus, it lends to other countries or buys net some assets so that other countries can pay their trade deficits.

19.2 THE GAINS FROM TRADE

Comparative advantage is the force that generates international trade.

Why the United States Exports AirplanesThe United States has a comparative advantage in the production of airplanes because the opportunity cost of producing an airplane is lower in the United States than in most other countries.

Figure 19.1 shows an export.

With no international trade, domestic purchases equal domestic production.


U.S. aircraft makers produce 400 airplanes and the price of an airplane is $80 million.

With international trade, the world market determines the world price at $100 million.


Domestic purchases decrease to 300 airplanes.

Domestic production increases to 800 airplanes.

The world price exceeds the domestic price of $80 million.

500 airplanes are exported.


Comparative Advantage

The U.S. aircraft makers have a comparative advantage in producing airplanes:

The world price line tells us that the world opportunity cost of producing an airplane is $100 million.

The U.S. supply curve shows that the U.S. opportunity cost of producing a plane is less than $100 million for all planes up to the 800th one.


Why the U.S. Imports T-shirts

More than half the clothing we buy is manufactured in other countries and imported into the United States.

Why?

The rest of the world (mainly Asia) has a comparative advantage in the production of clothes because the opportunity cost of produce a T-shirt in Asia is less than in the United States.

Figure 19.2 shows an import.


With no international trade, domestic purchases equal domestic production.

U.S. T-shirt makers produce 20 million T-shirts and the price of a T-shirt is $8.


With international trade, the world market determines the world price at $5 a T-shirt.

The world price is less than the domestic price of $8 a T-shirt.

Domestic purchases increase to 50 million T-shirts.

Domestic production decreases to zero.

50 million T-shirts are imported.

Reality check …

These are both lousy examples – sometimes even good textbooks have bad bits.

The airplane example is rotten because airplanes are complex differentiated goods, there are only three manufacturers of large commercial planes in the entire world, and there is no such thing as a “world price” for a ‘standard’ commercial airplane.

The T-shirt example is lousy because textiles and apparel trade is heavily regulated through an agreement called the ‘multi-fiber agreement,’ which puts quantitative limits on imports [some T-shirts are still made in the US, although that is ludicrously inefficient].

Think corn for the export; and aluminum for the import.


Gains from Trade and the PPF

We can use the PPF to show the gains from international trade between countries, exactly as we used it to show the gains from specialization and exchange between individuals.

Production Possibilities in the United States and China

Suppose that the United States produces only two goods: communication satellites and sports shoes. [Yes, you guessed it; this is going to be an oversimplified illustration.]

Suppose that China produces these same two goods.


If the United States uses all of its resources to produce satellites, its output is 10 satellites per year and no sports shoes.

If it uses all of its resources to produce sports shoes, its output is 100 million pairs of shoes and no satellites.

Assume that the U.S. opportunity cost of producing a satellite is constant.

The U.S. opportunity cost of producing 1 satellite is 10 million pairs of shoes.


If China uses all of its resources to make satellites, it can produce 2 satellites per year and no sports shoes.

If it uses all of its resources to produce sports shoes, it can produce 100 million pairs of shoes and no satellites.

Assume China’s opportunity cost of producing a satellite is constant.

China’s opportunity cost of producing 1 satellite is 50 million pairs of shoes.

Figure 19.3(a) shows the U.S. PPF.


Along the U.S. PPF, the opportunity cost of producing a satellite is constant.

The opportunity cost of a satellite is 10 million pairs of shoes.

With no international trade, the United States produces at point A.


Along China’s PPF, the opportunity cost of producing a satellite is constant.

The opportunity cost of a satellite is 50 million pairs of shoes.

With no international trade, China produces at point B.

Figure 19.3(b) shows China’s PPF.


No Trade

With no internationl trade:• The United States produces 5 satellites and 50

million pairs of shoes at point A on its PPF.

• China produces 2 satellites and no shoes at point B on its PPF.


Comparative Advantage

China has the comparative advantage in producing shoes.

• China’s opportunity cost of a pair of shoes is 1/50,000,000 of a satellite.

• The U.S. opportunity cost of a pair of shoes is 1/10,000,000 of a satellite.

China’s opportunity cost of shoes is lower than the United State’s, so China has a comparative advantage in producing shoes.


The United States has a comparative advantage in producing satellites.

• The U.S. opportunity cost of producing a satellite is 10 million pairs of shoes.

• China’s opportunity cost of producing a satellite is 50 million pairs of shoes.

The U.S. opportunity cost of a satellite is less than China’s, so the United States has a comparative advantage in producing satellites.


Achieving the Gains from Trade

The United States and China will reap the gains from international trade, if each country specializes [at least partially, not necessarily fully] in producing the good in which it has a comparative advantage and then the two countries trade with each other. Partial specialization means producing more of the good you specialize in than you would if there was no trade.

Figure 19.4 shows the gains from trade.


The United States specializes by producing 10 satellites at point P on its PPF.

China specializes by producing 100 million pairs of shoes at point Q on its PPF.

Figure 19.4 shows the gains from trade.


Both the United States and China gain because they both now consume outside their respective PPF’s.

China exports 90 million pairs of shoes to the United States and the United States exports 3 satellites to China.


With no trade, China produces 2 satellites and no shoes.

By specializing in producing shoes (the good in which it has a comparative advantage) and trading with the United States, China has 10 million pairs of shoes and 3 satellites.

China’s gains from trade are 10 million pairs of shoes and 1 satellite.


With no trade, the United States produces 5 satellites and 50 million pairs of shoes.

By specializing in producing satellites (the good in which it has a comparative advantage) and trading with China, the United States has 90 million pairs of shoes and 7 satellites.

The U.S. gains from trade are 40 million pairs of shoes and 2 satellite.

Where did those last number come from ?

We got the numbers on gains from trade from our assumption that the US traded with China at the price one satellite for thirty million shoes.

We don’t know that would be the price. We only know for trade to happen, the price must be somewhere between ten million and fifty million shoes [why? Because if not, trade does not produce a gain for one partner]. But where in between, which determines the distribution of the gains from trade, we don’t know without a whole lot more information [especially about supply and demand in each country].

Much of the difficulties about trade relations concern who benefits, the distribution of the gains [or losses] from trade.


Dynamic Comparative Advantage

Learning-by-doing occurs when people become more productive as a result of repeatedly performing the same task or producing a particular good or service.

Dynamic comparative advantage

A comparative advantage that a person (or country) obtains as a result of learning-by-doing.

19.3 TRADE RESTRICTIONS

Governments restrict trade to protect industries from foreign competition by using two main tools:

• Tariffs• Nontariff barriers

A tariff is a tax on a good that is imposed by the

importing country when an imported good crosses

its international border.

A nontariff barrier is any action other than a tariff that restricts international trade. The simplest example is a quota, that says only so much of a particular good can be imported, but there are hundreds of other possibilities.

Figure 19.5 shows the effects of a tariff.

The world price of a T-shirt is $5.


With free international trade, Americans buy 50 million T-shirts.

Suppose that the United States put a tariff on imported T-shirts.

The United States produces no T-shirts, so 50 million shirts are imported.

With a 50 percent tariff on T-shirts, the price in the United States rises from $5 to $7.50.


Americans buy 25 million T-shirts.

U.S. garment makers produce 10 million T-shirts.

Imports shrink to 15 million and the government collects tariff revenue (purple area).


Rise in Price of a T-shirt

The price of a T-shirt rises by 50 percent from $5 to $7.50 a shirt. Notice the price is higher for the US-made shirts as well as the imported ones; we are assuming they are perfect substitutes.

Decrease in Purchases

The quantity bought decreases from 50 million to 25 million a year.

Increase in Domestic Production

The higher price stimulates domestic production, which increases from zero to 10 million shirts a year.


Decrease in Imports

The quantity imported decreased from 50 million to 15 million a year—a decrease of 35 million shirts.

Tariff Revenue

The government collects tariff revenue of $2.50 per

shirt on the 15 million shirts imported, a tariff revenue

of $37.5 million a year


U.S. Consumers Lose

The opportunity cost of T-shirt is $5.

But Americans pay $7.50 for a T-shirt—$2.50 more than the opportunity cost of a shirt.

U.S. consumers are willing to buy 50 million shirts a year at the opportunity cost.

So the tariff deprives people of shirts that they are willing to buy at a price equal to the opportunity cost.

It is very unlikely that the gains to the US producers of T-shirts [over what they could make in their next best line of work] are as large as the costs to consumers in terms of higher prices paid and reduced consumption.


Nontariff Barriers

QuotaA specified maximum amount of a good that may be imported in a given period of time.

How a Quota Works

With free trade, Americans pay $5 a T-shirt and import 50 million T-shirts a year.

Suppose the U.S. government sets a quota on imported T-shirts of 15 million a year.

Figure 19.6 shows the effects of a quota.


With a quota, the supply of shirts in the U.S. market equals the supply by U.S. shirt makers plus the quota on imports.

The price Americans pay is determined in the U.S. shirt market and it rises to $7.50 a shirt.


With the higher price, U.S shirt makers increase production to 10 million a year.

Imports decrease from 50 million to 15 million shirts, which equals the quota.

Americans buy 25 million shirts a year—down from 50 million a year.

Comparison …

Notice that the effect of the quota, restricting imports to the same amount the tariff would have, is identical – higher price, lower imports and consumption – as with the tariff, except that now there is no tariff revenue – instead that becomes a ‘rent’ to whoever gets the import permits.

This equivalence of tariffs and quotas is crucially dependent on the [unstated] assumption in the analysis above that both the domestic and foreign markets are competitive – i.e. many buyers and sellers of fairly standard products. If this is not correct – there is monopoly or highly differentiated products – the equivalence will not hold, and quotas are likely to be more costly and damaging than tariffs.

Protection -- Voluntary Export Restraints

GATT [General Agreement on Tariffs and Trade] and the WTO [World Trade Organization] forbid new quotas or tariffs for rich-country members

“Voluntary Export Restraints,” VER’s, are an evasion -- the importing country persuades the exporter to “voluntarily” restrain their exports

The effect is similar to a quota, except that the rent -- the tariff-revenue equivalent -- goes to the exporters, not the importers.


Health, Safety, and Other Nontariff Barriers

Thousands of detailed health, safety, and other regulations restrict international trade.

Some examples are:

All imports of food products into the United States must meet the Food and Drug Administration’s standards.

The European Union has banned all imports of genetically modified foods, such as U.S.soybean and Canadian granola.

Australia bans imports of Californian grapes to protect its domestic grape industry from a vine virus found in California.

19.4 THE CASE AGAINST PROTECTION

Three Arguments for Protection

• The national security argument• The infant-industry argument• The dumping argument


The National Security Argument

The argument that a country must protect industries that produce equipment and armaments and those on which the defense industries rely on for their raw materials.

This argument does not withstand close scrutiny.• In a time of war, all industries contribute to

national defense.• To increase the output of a strategic industry, it is

more efficient [less costly] to use a subsidy rather than a tariff or quota.


The Infant-Industry Argument

The argument that it is necessary to protect a new industry to enable it to grow into a more mature industry that can compete in world markets.

Valid only if the benefits of learning-by-doing not only accrue to the owners and workers of the firms in the infant industry but also spill over to other industries and parts of the economy.


The Dumping Argument

Dumping occurs when a foreign firm sells its exports at a lower price than its cost of production. We get the goods cheaply, what is the problem?

The protectionist argument is that a firm that wants to become a global monopoly might try to eliminate its foreign competitors by dumping. Once it has a global monopoly, it will raise its price. For most goods, this is highly unlikely.

Dumping is permitted as justification for temporary countervailing duties by international agreements, in order to reduce disruption of domestic markets. Anti-dumping duties are invariably controversial.

• The Dumping argument

“Dumping occurs when a foreign firm sells its exports at a lower price than its costs of production.”

The dumping argument should be restricted, because:Dumping is very hard to ‘prove’ -- criteria tend to be unilateral,

set by the importing country.

When/if it happens, dumping benefits domestic consumers -- they get the goods cheaper.

One country having a global monopoly is not likely.

Regulation would be the best way of dealing with a global monopoly if it existed.


Fatally Flawed Arguments for Protection

Saves Jobs

The argument is that protection saves jobs because when we buy shoes from Brazil or shirts from Taiwan, U.S. workers lose their jobs.

Allows Us to Compete with Cheap Foreign Labor

The argument is that with the removal of protective tariffs in U.S. trade with Mexico, jobs rushing to Mexico would make a “giant sucking sound.”

• The Saving Jobs argument

“When we buy shoes from Brazil, U.S. workers lose their jobs.”

The saving jobs argument is flawed, because:Free trade does cost some jobs, but it also

creates jobs. Full employment is a macro issue, not a micro one.

ITC estimated that because of quotas, 72,000 jobs exist in U.S. textiles that would otherwise disappear. Clothing expenditures are $160 per family higher per year as a result. Average earnings for those jobs: under $20,000 a year; annual cost per job saved: over $200,000.

• The Allow us to compete with cheap foreign labor argument

Many fear that free trade will lower US wages to Asian or Mexican levels.

Consider this:High wage U.S. workers are more productive, on average,

than low-wage foreign workers.

The U.S. should specialize in activities where it has a comparative advantage.

Many goods and services are untradable; less skilled workers in the US earn more than in lower income countries, and will continue to.


Brings Diversity and Stability

The argument is that protection brings a diversified economy—an economy that fluctuates less than one that produces only a few goods and services.

Penalizes Lax Environmental Standards

The argument is that many poor countries, such as Mexico, do not have the same environmental standards as the U.S., so we cannot compete without tariffs.


Protects National Culture

The argument that is commonly heard in Canada and Europe is that free trade in books, magazines, movies, and television programs means U.S. domination and the end of local culture.

Prevents Rich Countries from Exploiting Developing Countries

The argument is that if we trade with developing countries in which the wage rate is low, we increase the demand for the goods they produce and so increase the demand for their labor.

Why flawed?

None of these arguments disprove the basic result that specialization in those activities in which a country has comparative advantage will produce the largest possible consumption possibilities. So long as we can maintain full employment [a macro policy issue, not a trade issue], we are better off with freer trade than with more restricted trade.

We might want to achieve a non-economic objective like home-produced magazines or TV programs. Then be honest, that is what we want to do, and it will cost us. Trade restrictions typically hide the cost and make it larger than necessary; a straight subsidy would usually be cheaper and clearly more honest.

Trade restrictions also have important distributional effects.


Why Is International Trade Restricted?Two key reasons:• Tariff revenue• Rent seeking

Tariff RevenueOnly a negligible part of the U.S. government’s revenue comes from taxes.But in some developing countries, governments have limited ability to collect other forms of taxation at reasonable cost. In such countries, international trade transactions are often concentrated and relatively easy to tax, so governments use tariffs on imports [and/or export taxes] to raise revenue.


Rent Seeking

Rent seeking is lobbying and other political activity that seeks to capture the gains from trade.

Free trade increases consumption possibilities overall, but not every individual gains. Free trade brings benefits to some and costs to others. Gainers are consumers of cheaper imports and producers of exports. Those who produce import-competing goods tend to lose from freer trade.

The uneven distribution of benefits and costs is the principle source of impediment to freer international trade.


Compensating Losers

In total, the gains from free international trade exceed the losses, so why don’t the people who gain from free trade compensate the losers?

To a degree, losers are compensated: When Congress approved the NAFTA deal with Canada and Mexico, it set up a $56 million fund to support and retrain workers who lost their jobs because of the free trade agreement.


During the first six months of NAFTA, only 5,000 workers applied for benefits under the scheme.

But in general, we don’t compensate the losers from free international trade. The political reality is that protectionism is a popular and permanent feature of our economic and political life, largely because of misunderstanding and misinformation.

Free Trade has net benefits

A shift from protection to free-er trade helps some [usually consumers, exporters], hurts others [those engaged in the formerly protected activity]

Benefits to gainers are almost always larger [often much larger] than losses to losers

Why then protection?

Political Economy of Protection

Those who gain from protection [lose from free trade] tend to be concentrated and stand to lose much each [e.g. apparel workers and their jobs] without protection.

Those who lose from protection [gain from free trade] tend to be diffuse and to gain little each [e.g. slightly lower prices on clothes] from the removal of protection, and not even know or know how much.

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CHAPTER 19: International Trade CHAPTER 19: International Trade