Principles Of EconomicsPrinciples Of Economics

Power Point Presentation

Chapter 16

Free Trade: To Be Or Not To Be

©J. Patrick Gunning

April 23, 2007

IntroductionIntroduction During the past 60 years, the prosperity of the

world has been largely due to the growth of world trade. Economic growth in the more advanced nations has been the highest in history.

Yet many people oppose free international trade. Main purpose of the chapter:

1. To describe the nature of a free trade regime. 2. To present arguments in favor of restricting trade along

with counterarguments.

New TopicNew Topic: The Nature of a Free : The Nature of a Free International Trade RegimeInternational Trade Regime

Four components of a free international trade regime:

1. Freedom of trade in material consumer goods and resources.

2. Freedom of trade in services. 3. Freedom of capital flows. 4. Freedom of human being movement.

Ways Of Restricting Trade In Ways Of Restricting Trade In Material Goods And ResourcesMaterial Goods And Resources

People can import or export whatever goods they wish.

Limitations of economics: economists can say nothing about which goods and resources should be considered dangerous (weapons, toys, household cleaners) or which goods should be taboo (drugs, pornography). It is concerned with other goods.

Ways to restrict trade: tariffs, quotas, quality standards (from Chapter 15)

Freedom Of Trade In ServicesFreedom Of Trade In Services Services do not or need not have material

substance. Example: Movies supplied by means of

discs or tapes have material substance. Since movies can also be supplied through

TV sets and over the internet, they may also not have material substance.

Kinds Of Services That Are Relevant Kinds Of Services That Are Relevant To International Trade (1)To International Trade (1)

1. Services associated with trade in material goods or resources — retailing, purchasing, translation, transport, etc.

2. Entertainment services, like music, movies, and gaming.

3. Communication infrastructure services, such as phone services, chat and intermediary entrepreneurship.

Kinds Of Services That Are Relevant Kinds Of Services That Are Relevant To International Trade (2)To International Trade (2)

4. Human capital services – information and teaching.

5. Agency services – engineers, doctors legal advisors, psychiatrists.

6. Pooling of risk or uncertainty services – insurance.

Comments On Services (1)Comments On Services (1)

If physical presence is required or if it is the cheapest way to supply a particular service, a nation can restrict trade in services by imposing a special tax on foreign providers, setting a quota, or requiring them to meet quality standards.

Comments On Services (2)Comments On Services (2) Today many services of this type are provided

through electronic communication. To control them would require control over

international communication. Due to the dynamic nature of international

communication and the possibilities of regulating it, it is difficult to say much about these without an extensive discussion of complex technology.

Freedom Of Capital FlowsFreedom Of Capital Flows Capital flow: an inflow or outflow of purchasing

power that is not due to trade in goods, resources or services.

A capital outflow from the U.S. does not mean that dollars leave the U.S. It means that dollars are converted into a foreign currency and that the foreign currency is sent out.

It is similar to buying a foreign good, resource or service.

Sources Of Capital OutflowsSources Of Capital Outflows 1. Gifts: for example, a remittance by a guest worker. 2. Earnings by foreign investors or savers that are taken

out. 3. New citizen investment or saving in other countries. 4. Money that accompanies a change of national

residence – a citizen travels to or emigrates to a foreign country.

Sources of inflows are the opposite.

DefinitionsDefinitions Currency market: a market in which people

exchange one type of currency for another. (Example: a traveler to Mexico.)

Flexible exchange rate system: nations permit the rate of exchange between their currency and the currencies of other nations to change as the demands for their currency changes and as their citizens demands for the currencies of other nations change.

Effects Of An Inflow Of CurrencyEffects Of An Inflow Of Currency An inflow of currency into the U.S. does not mean

that dollars flow into the U.S. It means that the foreign currency is used to buy dollars.

Because of the flexible exchange rate system, the value of the dollar rises in terms of that currency. For example, an inflow of currency from Europe means that the value of the dollar rises in terms of the Euro.

ExampleExample Suppose that economic conditions in the U.S. and

Europe do not change for many years and that the exchange rate of euros for dollars is 1$ = €1.

Conditions change so that more European capital than usual flows into the U.S. The exchange rate would rise to, say, $1 = €1.1. A U.S. shopper traveling to Europe could buy 10% more.

If more U.S. capital flows into Europe, the exchange rate might fall to, say, $1 = €.9. The shopper would be able to buy about 11% less.

Exchange Rate Of The Dollar For Exchange Rate Of The Dollar For Euros And Yen (Figure 14-3)Euros And Yen (Figure 14-3)

The European ViewThe European View

Restrictions On Capital FlowsRestrictions On Capital Flows Capital control: a restriction on the inflow or

outflow of a nation’s currency in a world where different nations use different currencies.

Examples Special taxes on converting currency or on the rate of

return to foreigners’ saving and investment. Discrimination against foreign ownership of assets, such

as shares of stock in domestic corporations. Quotas on the conversion of local currency into foreign

currency for purposes other than trade in material goods and resources.

Preferences Of LeadersPreferences Of Leaders Some leaders prefer a valuable currency.

To get it, they can try to increase the inflow of capital and reduce the outflow.

Some leaders prefer a cheap currency in order to increase exports.

Capital controls are a means of achieving a target exchange rate for the currency of another nation.

The Asian Financial Crisis (1)The Asian Financial Crisis (1) In the 1990s U.S. and European investors

and savers found that rates of return and interest rates where higher in Asia (South Korea, Taiwan, Hong Kong, Thailand, Malaysia, and Indonesia) than in their own countries.

The value of these currencies was high as capital flowed in.

The Asian Financial CrisisThe Asian Financial Crisis In 1997, a contraction led to a sharp decrease in

business profit. Some businesses failed and some loans were not repaid.

Foreigners sold off their stock quickly and did not renew their loans.

They initiated a capital outflow by converting their foreign currency into dollars.

The exchange rates of these Asian currencies fell. Example Thai baht fell from $1 = 25 baht to $1 = 50 baht.

The Asian Financial CrisisThe Asian Financial Crisis Some governments instituted capital

controls at that time in order to prevent the value of their currencies from falling further.

Some governments also began to restrict foreign investment and saving in their countries.

What Causes Changes in anWhat Causes Changes in anExchange Rate?Exchange Rate?

Changes in the exchange rate of a nation’s currency are caused by: 1. Ordinary demands for and supplies of a

nation’s currency that arise from factors relating to international trade.

2. Macroeconomic performance of one’s nation in relation to the performance of other nations.

3. Expectations about macroeconomic performance – due to exchange rate speculation.

Ordinary Demands For And Supplies Ordinary Demands For And Supplies Of A Nation’s CurrencyOf A Nation’s Currency

A. The relative prices of goods, resources, and services in different nations.

B. Desires to send gifts abroad, investments, travel and establishing residence.

Expectations About Macroeconomic Expectations About Macroeconomic Performance and Policies (1)Performance and Policies (1)

If investors expect economic growth and no inflation in a foreign country’s currency, they would expect the exchange rate of the currency to rise in the more distant future.

They would try to buy it now in order to sell it later.

Their buying would increase the demand for it now and raise the exchange rate in the nearer future.

Expectations About Macroeconomic Expectations About Macroeconomic Performance and Policies (2)Performance and Policies (2)

If investors expect inflation in a foreign country’s currency and poor economic performance, they would expect the exchange rate of the currency to fall in the more distant future.

They would try to sell it now in expectation of buying it back in the more distant future.

Their selling would decrease the demand for it now and reduce the exchange rate of that nation’s currency in the nearer future.

Other ExpectationsOther Expectations Expectations about laws and private

property rights.

Freedom Of Human Being MovementFreedom Of Human Being Movement The most complete freedom of human being

movement would be free immigration and emigration.

Practically all nations restrict immigration, although they also normally allow it under certain conditions. Such conditions may be very liberal or they may be very conservative.

See http://www.pstalker.com/migration/mg_map.htm

Migration PatternsMigration Patterns

The number of foreign-born in the U.S. is at an all-time high, but their share of the total population is still

below that of 1910.Foreign-born population, United States, 1850-2005

Source: U.S. Census Bureau.

Natural increase still accounts for almost 60% of Natural increase still accounts for almost 60% of population growth in the u.s., but the share from population growth in the u.s., but the share from

international migration has been increasing.international migration has been increasing.Percent of U.S. population growth due to natural increase and net migration, 1980-2005

Source: U.S. Census Bureau.

Percent of immigrants admitted to the United States, by region of origin, 1961-2004

Source: U.S. Department of Homeland Security, Office of Immigration Statistics, 2004 Yearbook of Immigration Statistics (2005).

The largest share of immigrants to the U.S. still comes The largest share of immigrants to the U.S. still comes from latin America, but the share coming from asia has from latin America, but the share coming from asia has

increased substantially since the 1960s.increased substantially since the 1960s.

Source: U.S. Census Bureau, 1990 decennial census.

In 1990, almost half of all U.S. counties had less than 1% In 1990, almost half of all U.S. counties had less than 1% foreign-born, and only one-tenth had 5% or more.foreign-born, and only one-tenth had 5% or more.

Source: U.S. Census Bureau, 2000 decennial census.

By 2000, only one-fourth of U.S. counties had less than 1% By 2000, only one-fourth of U.S. counties had less than 1% foreign-born, and one in five had 5% or more.foreign-born, and one in five had 5% or more.

New Topic: The Logic Of the Case For Free International Trade

Free trade, at a minimum, means the absence of tariffs, quotas, and discriminatory standards in goods.

Free trade can be applied to services, capital flows, and even movement of people.

No nation has a completely free trade regime, even with respect to material goods and resources.

In making realistic statements about a nation’s trade policies, economists ordinarily write about “freer” trade, rather than completely free trade.

Viewpoints Of Free And Freer TradeViewpoints Of Free And Freer Trade Economists generally agree that allowing

greater freedom in trade has enabled leaders of less developed nations to grow more rapidly than otherwise.

Who opposes freer trade: 1. Producers and resource suppliers who are harmed are

typically opposed. 2. People who do not realize how they benefit from trade

as resource suppliers and consumers or how much they benefit.

Four Logical Reasons Why There Are Four Logical Reasons Why There Are Gains From Free International TradeGains From Free International Trade

1. The principle of comparative advantage, or lowest opportunity cost.

2. The greater incentive in the presence of international trade to produce specialized human capital.

3. Reductions in the standard of living due to foreign competition motivate citizens to increase their specialized human capital.

4. Copying and synergy that results from inter-cultural interaction.

The Principle Of Comparative The Principle Of Comparative Advantage, Or Lowest Opportunity CostAdvantage, Or Lowest Opportunity Cost Even if the people of a poor nation are less

able, in terms of work time, to produce all goods, they almost certainly have lower opportunity costs in producing some goods than others.

The people can gain by specializing in producing those goods and trading them for the goods of other nations for which their opportunity costs are comparatively high.

People Have A Greater Incentive In The People Have A Greater Incentive In The Presence Of International Trade To Presence Of International Trade To Produce Specialized Human CapitalProduce Specialized Human Capital

The prospect for gaining from exchange raises the demand, making the production of new specialized human capital profitable.

Even if a nation has no comparative advantage, its citizens could still gain from specialization and trade by first improving their abilities to produce a particular good and then offering it for trade in international markets.

Foreign Competition Motivates Citizens Foreign Competition Motivates Citizens To Produce Specialized Human CapitalTo Produce Specialized Human Capital

In the international trading system, the people of each nation gain from increased competition from newcomers to the global economy because the competition spurs both innovation and copying throughout the entire global economy.

Inter-cultural Copying And SynergyInter-cultural Copying And Synergy An example of a foreign firm that is permitted to

produce a product for domestic consumption. It hires domestic managers, engineers, etc. The local managers copy the foreigners, start

their own business, and ultimately compete in international markets.

Technology transfer. the transfer of technology possessed by the citizens of a more advanced nation to citizens of a less advanced nation.

Limitations of the Case for Limitations of the Case for International Trade International Trade

The gains for trade argument applies to the nation as a whole.

There are individual losers. No one can say that the loses do not lose more,

in terms of happiness, than the gainers gain. We can only say that it would be possible for the

gainers to compensate, in money, for the losses of the losers.

New TopicNew Topic: Protectionist Arguments : Protectionist Arguments And CounterargumentsAnd Counterarguments

1. Workers and domestic producers should receive protection.

2. Infant industries should receive temporary protection.

3. Winners should be picked to receive protection. 4. Entrepreneurs and resource suppliers should

receive protection from unfair competition. 5. Entrepreneurs and resource suppliers should

receive protection from competitors who use detestable methods of production.

First Argument:First Argument: The Jobs Argument The Jobs Argument The argument: workers and domestic

producers should receive protection against foreign competition.

To evaluate this argument, we consider a case in which the harm due to foreign competition is identical to the harm caused by a hypothetical innovation from within the country.

Assessment Of Gains And LossesAssessment Of Gains And Losses Producers and suppliers of resources who

use the old methods lose. Producers and suppliers of resources who

use the new methods gain. Consumers gain.

Hypothetical Effects of Removing a Hypothetical Effects of Removing a Tariff on Foreign Sugar (Figure 16-4)Tariff on Foreign Sugar (Figure 16-4)

Explanation of Figure 16-4Explanation of Figure 16-4 Consumers buy at the world price of $6.50

per bag instead of at the pre-trade domestic price of $11.20 per bag.

Consumers increase their purchases from 252 to 386 bags

Domestic supply falls from 252 bags per day to 130 bags.

256 bags of sugar are imported.

Avoidable and Unavoidable Losses Avoidable and Unavoidable Losses (Figure 16-5)(Figure 16-5)

Explanation of Figure 16-5Explanation of Figure 16-5 Area B are avoidable losses because

entrepreneurs and workers have alternative employments.

Area A are the unavoidable losses.

Gains and Losses From TradeGains and Losses From Trade(Figure 16-6)(Figure 16-6)

Explanation of Figure 16-6Explanation of Figure 16-6 The harm to domestic producers is area A. The benefits to domestic consumers is the

total area A + B + C. Consumers who would have bought at the

higher price gain A + B. Consumers who decide to buy only because the price is lower gain C.

Relative Size of the Relative Size of the Personal Gains and LossesPersonal Gains and Losses

There are ordinarily many consumers. Each gains only a small amount from eliminating a tariff.

There are ordinarily only a few entrepreneurs and a small number of workers. Each loses a larger amount than the consumers.

Because the losses are larger and more visible, the media often focus on them instead of on the gains.

Do Entrepreneurs and Workers as a Do Entrepreneurs and Workers as a Whole Lose?Whole Lose?

An increase in imports also raises the amount of spending on other goods, resources, or services. Thus, it not only reduces employment in the sugar industry, it raises employment elsewhere.

Because this other spending is hidden from view, we must follow the money to discover them.

Following The MoneyFollowing The Money Two cases: both assume that lower-priced sugar

is bought by U.S. Citizens from Mexico. Both also assume that to buy the Mexican sugar, a U.S. importer must exchange dollars for pesos.

1. The dollars acquired by the Mexicans are used to buy U.S. Goods.

2. The dollars acquired by the Mexicans are saved in the U.S.

First CaseFirst Case: Dollars Are Used To Buy : Dollars Are Used To Buy U.S. Goods (1)U.S. Goods (1)

Simplest case: all the dollars are used to buy U.S. apples. The buyer of sugar exchanges the dollars with a Mexican who aims to import apples.

Then the U.S. apple industry will expand to the same extent that it would if there was an offsetting increase in demand for apples and decrease in demand for sugar.

Recall that economists have no reason to believe that the producers and suppliers of resources to sugar would lose more than the producers and suppliers of resources to apples.

First CaseFirst Case: Dollars Are Used To Buy : Dollars Are Used To Buy U.S. Goods (2)U.S. Goods (2)

In this case, we know that consumers as a group gain because the resources that must be sacrificed to produce the apples for export are worth less to the entrepreneurs than the resources that are saved because less domestic sugar is produced.

The reason is the principle of comparative advantage.

First CaseFirst Case: Dollars Are Used To Buy : Dollars Are Used To Buy U.S. Goods (3)U.S. Goods (3)

Conclusion: trade is beneficial in net because consumers gain and there is no way to determine whether producers and resource suppliers in the expanding industry gain more or less than the producers and resource suppliers who competed with the good that is imported.

First CaseFirst Case: Dollars Are Used To Buy : Dollars Are Used To Buy U.S. Goods (4)U.S. Goods (4)

Addendum: Mexican importers who trade pesos for dollars are likely to buy a variety of U.S. goods. If so, there will be increases in the demands for that variety. The beneficial effects on resource suppliers will occur in a variety of industries and, as a result, less obvious. But they are similar.

Second CaseSecond Case: Dollars Are Saved In The : Dollars Are Saved In The U.S. Or Used To Buy U.S. PropertyU.S. Or Used To Buy U.S. Property

The buyer of Mexican sugar exchanges the dollars with a Mexican who aims to save in the form of a U.S. time deposit or U.S. property.

Dollars Are Used To MakeDollars Are Used To MakeA Time Deposit (1)A Time Deposit (1)

When the dollars are put into loanable funds markets, the interest rates will fall.

U.S. businesses will borrow the funds and invest them in production projects, R&D, or upgrading.

It is as if there has been a decrease in U.S. near-future goods demand.

Some U.S. savers are likely to consume more goods in the near future due to the lower interest rate. So there will also be an increase in the production of goods that these savers consume.

Dollars Are Used To MakeDollars Are Used To MakeA Time Deposit (2)A Time Deposit (2)

The end result? The increase in derived demand for resources due to increased business investment and to increased U.S. demands for other goods will offset the decrease in derived demand for resources in the sugar industry.

Consumers of sugar will gain.

Dollars Are Used To Buy U.S. Dollars Are Used To Buy U.S. Property (1)Property (1)

When the dollars are transferred to former U.S. property owners, they will either save them or spend them on consumer goods.

If they save, U.S. businesses will borrow the funds and invest them in production projects, R&D, or upgrading.

If they spend on consumer goods, there will be an increase in the production of goods that these former property owners consume.

Dollars Are Used To Buy U.S. Dollars Are Used To Buy U.S. Property (2)Property (2)

The end result? The increase in derived demand for resources due to increased U.S. business investment and to increased U.S. demands for other goods will offset the decrease in derived demand for resources in the sugar industry.

Consumers of sugar and U.S. property owners will gain.

Eliminating a Tariff is Like a Eliminating a Tariff is Like a Technological AdvanceTechnological Advance

An example of sugar.

Consider a college grad who has just discovered a synthetic way to make sugar and is hired by an entrepreneur.

His ideas revolutionize the sugar industry, leaving producers who use the old methods with no opportunity to profit.

Producers and resources suppliers who use the old methods are harmed.

Competition From Foreign Sugar Competition From Foreign Sugar ProducersProducers

Assume that the foreigners reduce price to exactly the same price charged by the domestic producer who we assumed developed a new method of production.

Then: 1. Producers and resource suppliers of sugar

would lose the same amount as in the case of the domestic innovation.

2. Consumers would gain the same amount.

ConclusionConclusion Arguments that focus exclusively on

workers and business that are harmed by imports fail to recognize that trade is based on comparative advantage.

Failure to realize this conclusion is due to the failure to follow the money.

Second ArgumentSecond Argument: Infant Industry : Infant Industry ArgumentArgument

The argument: some firms or industries, like children, need protection when they are infants. With protection, they can grow up to be profitable. Without it, they may perish. Therefore, a government should temporarily protect such firms and industries from competition.

Example: a ban in imports of cars in order to help a fledgling domestic automobile industry.

Counter-argumentCounter-argument Helping firms in an infant industry entrusts the task of

picking the infants to government agents, who do not have the profit incentive. It is unnecessary and may lead to waste and corruption.

Helping firms in an infant industry amounts to trying to transform an industry in which a nation has a comparative disadvantage into one for which it has a comparative advantage. Helping industries in which a nation has a comparative advantage or no advantage seems more desirable.

Picking Winners PolicyPicking Winners Policy Picking winners policy: A government policy

of attempting to distinguish entrepreneurs or lines of business that are likely to be profitable – the winners – from those that will not be. The winners are then given special incentives by the government to expand their businesses.

Counter-argumentCounter-argument See the counter-argument to the infant

industry argument. It is the same.

Third Argument:Third Argument: Unfair Competition Unfair Competition ArgumentArgument

Unfair competition in international trade: a foreign firm is receiving some kind of help from its government that is not being given to a domestic firm.

Argument And Counter-argumentArgument And Counter-argument Unfair competition argument in international

trade: domestic firms should be protected from unfair competition.

Counter-argument: to best benefit domestic citizens, a nation should permit them to buy from the cheapest sellers, whether they are being helped by a foreign government or not.

AnalysisAnalysis Assume that a foreign government

subsidizes an international firm, enabling it to sell at a lower price in a domestic industry.

It is as if the foreign government is subsidizing domestic consumers. It is providing them with a gift.

DumpingDumping Dumping in international trade: a foreign

firm is selling to domestic consumers at a lower price than its costs of production.

Dumping is usually the result of a subsidy.

Fourth Argument:Fourth Argument: Detestable DetestableMethods Argument (1)Methods Argument (1)

Examples of detestable methods: use of child labor, prisoner labor, or slave labor; use of labor that is not permitted to organize or to threaten strikes for higher wages.

Fourth Argument:Fourth Argument: Detestable DetestableMethods Argument (2)Methods Argument (2)

Detestable methods argument in international trade: domestic firms should be protected from foreigners who use detestable methods of production.

Counter-argument: To best benefit domestic citizens, a nation should permit them to buy from the cheapest sellers, regardless of their methods of production.

Sending a MessageSending a Message A trade barrier may be employed to send a

message that leaders or citizens do not approve of methods regarded as detestable.

But is this the best way to send the message?

One must take account of the benefits of the trade and the costs of the alternatives.

Free Trade And External EffectsFree Trade And External Effects External effects argument in international trade:

domestic firms should be protected from foreigners who are permitted to cause external effects when domestic firms are prohibited from doing so.

Counter-argument: To best benefit domestic citizens, a nation should permit them to buy from the cheapest sellers, regardless of how other foreigners are affected.

““Race To The Bottom”Race To The Bottom” This is a phrase used to represent the idea

that leaders of foreign governments may compete with each other in an effort to supply goods to other nations at the lowest costs by permitting producers to harm their citizens.

Unproductive Activities Resulting Unproductive Activities Resulting From ProtectionismFrom Protectionism

Such activities are encouraged by a government that sometimes responds to protectionist arguments. It is especially important in less developed economies.

Two types: 1. Actions aimed at changing a law in order to

protect a firm from competition. 2. Actions aimed at changing the enforcement of

a law in order to protect a firm from competition.

New Topic:New Topic: Dealing With Opposition Dealing With Opposition To Free Trade In A DemocracyTo Free Trade In A Democracy

Three Methods: 1. Compensating losers. 2. Making trade agreements. 3. Using economics.

Compensating LosersCompensating Losers Goal: to impose a temporary tax on the consumers of sugar

in order to compensate the producers and resource suppliers.

Everyone could gain. The revenue collected from the sales tax would be separated

from other taxes and put into a special subsidy fund for sugar producers and workers in proportion to the loss they incur.

It would then be divided among the producers and resources suppliers according to each one’s share of the total revenue received in the industry.

Such a program should be gradually phased out.

Making Trade AgreementsMaking Trade Agreements A bilateral trade agreement may help create

support from prospective suppliers of exports to the country with which the agreement is made.

A multilateral trade agreement may even be better.

Less developed nations that are not members of the WTO can enter such an agreement simply by joining.

Using EconomicsUsing Economics 1. Economists can enlighten those who are

unaware of the benefits they receive. They can also inform people about the incentives of potential losers from freer trade to influence laws and sway public opinion.

2. Economists can devise and recommend plans aim to compensate losers from trade.