Unit IVInternational Trade (Chapter 8)

In this chapter, look for the answers to these questions:What determines how much of a good a country

will import or export?

Who benefits from trade? Who does trade harm? Do the gains outweigh the losses?

How do tariffs and import quotas cause inefficiency and reduce total surplus?

Why do governments often engage in trade protection to shelter domestic industries from imports and how do international trade agreements counteract this?

The World Price and Comparative Advantage

• PW = the world price of a good, the price that prevails in world markets

• PD = domestic price without trade

• If PD > PW, – country does not have comparative advantage – under free trade, country imports the good– There are overall gains from trade because consumer

gains exceed the producer losses.• If PD < PW,

– country has comparative advantage in the good– under free trade, country exports the good– There are overall gains from trade because producer gains

exceed the consumer losses.

The Small Economy Assumption

• A small economy is a price taker in world markets: Its actions have no affect on PW.

• Not always true – especially for the U.S. – but simplifies the analysis without changing its lessons.

• When a small economy engages in free trade,PW is the only relevant price:

– No seller would accept less than PW, because she could sell the good for PW in world markets.

– No buyer would pay more than PW, because he could buy the good for PW in world markets.

A Country That Exports Soybeans

Without trade, PD = $4

Q = 500

PW = $6

Under free trade, – domestic

consumers demand 300

– domestic producers supply 750

– exports = 450

P

QD

S

$6

$4

500300

Soybeans

exports

750

A Country That Exports SoybeansWithout trade,CS = A + B

PS = C

Total surplus = A + B + C

With trade, CS = A

PS = B + C + D

Total surplus = A + B + C + D

P

QD

S

$6

$4

Soybeans

exportsA

B D

Cgains

from trade

total surplus

producer surplus

consumer surplus

direction of trade

rises

falls

rises

imports

PD > PW

rises

rises

falls

exports

PD < PW

Summary: The Welfare Effects of Trade

Whether a good is imported or exported, trade creates winners and losers. But the gains exceed the losses.

Other Benefits of International Trade

• Consumers enjoy increased variety of goods.• Producers sell to a larger market and may achieve

lower costs through economies of scale.• Competition from abroad may reduce market

power of some firms, which would increase total welfare.

• Trade enhances the flow of ideas, facilitates the spread of technology around the world

• PROBLEM -- there are losers in free trade– SOLUTION -- winners compensate the losers

(seldom done)

Effects of Trade Protection• An economy has free trade when the

government does not attempt either to reduce or to increase the levels of exports and imports that occur naturally as a result of supply and demand. Policies that limit imports are known as trade protection or simply as protection.

• Most economists advocate free trade, although many governments engage in trade protection of import-competing industries. The two most common protectionist policies are tariffs and import quotas. In rare instances, governments subsidize export industries.

Effects of a Tariff• A tariff is a tax levied on imports. • It raises the domestic price above the

world price, leading to a fall in trade and total consumption and a rise in domestic production.

• Domestic producers and the government gain, but consumer losses more than offset this gain, leading to deadweight loss in total surplus.

Tariff: An Example of a Trade Restriction

• Tariff: a tax on imports

• Example: Cotton shirtsPW = $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 ).

$30

Analysis of a Tariff on Cotton Shirts

PW = $20

free trade:buyers demand 80sellers supply 25imports = 55

T = $10/shirtprice rises to $30buyers demand 70sellers supply 40imports = 30

P

Q

D

S

$20

25

Cotton shirts

40 70 80

importsimports

$30

Analysis of a Tariff on Cotton Shirtsfree tradeCS = A + B + C

+ D + E + FPS = GTotal surplus = A + B

+ C + D + E + F + G

tariffCS = A + BPS = C + GRevenue = ETotal surplus = A + B

+ C + E + G

P

Q

D

S

$20

25

Cotton shirts

40

A

B

D E

GFC

70 80

deadweight loss = D + F

$30

Analysis of a Tariff on Cotton Shirts

D = deadweight loss from the overproduction of shirts

F = deadweight loss from the under-consumption of shirts

P

Q

D

S

$20

25

Cotton shirts

40

A

B

D E

GFC

70 80

deadweight loss = D + F

Import Quotas: Another Way to Restrict Trade

• An import quota is a quantitative limit on imports of a good.

• Mostly, has the same effects as a tariff:– raises price, reduces quantity of imports– reduces buyers’ welfare– increases sellers’ welfare

• A tariff creates revenue for the govt. A quota creates profits for the license holder

Trade Protection in the United States

The United States today generally follows a policy of free trade. Most manufactured goods are subject either to no or a low tariff.

There are two areas where imports are limited: Agriculture: A certain amount of imports are subject to low a

tariff rate and this acts like an import quota because only importers that are license holders are allowed to pay the low rate. Any additional imports are subject to a higher tariff.

Clothing and Textiles: A surge of clothing from China led to a partial re-imposition of import quotas which had otherwise been removed at the start of 2005.

In most cases, quota licenses are assigned to foreign governments. Quota rents greatly go overseas, increasing the cost to the U.S. of foreign imports.

Trade Protection in the United States

There isn’t much U.S. trade protection. According to official U.S. estimates, the total

economic cost of all quantifiable restrictions on imports is about $3.7 billion a year, or around one-fortieth of a percent on national income. Of this, about $1.9 billion comes from restrictions on clothing imports, $0.8 billion from restrictions on sugar, and $0.6 billion from restrictions on dairy. Everything else is small change.

Arguments for Trade Protection• Advocates of tariffs and import quotas

offer a variety of arguments. Three common arguments are:–national security– job creation– the infant industry argument

• Despite the deadweight losses, import protections are often imposed because groups representing import-competing industries are smaller and more cohesive than groups of consumers.

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

New Challenges to Globalization

• There are two concerns shared by economists:– Worries about the effects of globalization on

inequality.– Worries that new developments, in particular

the growth in offshore outsourcing, are increasing economic insecurity.

Offshore outsourcing takes place when businesses hire people in another country to perform various tasks.

CHAPTER SUMMARY A country will export a good if the world price of the good is higher than the domestic

price without trade. Trade raises producer surplus, reduces consumer surplus, and raises total surplus.

A country will import a good if the world price is lower than the domestic price without trade. Trade lowers producer surplus, but raises consumer and total surplus.

International trade leads to expansion in exporting industries and contraction in import-competing industries.

Most economists advocate free trade, but in practice many governments engage in trade protection.

A tariff is a tax levied on imports. An import quota is a legal limit on the quantity of a good that can be imported.

Although several popular arguments have been made in favor of trade protection, in practice the main reason for protection is probably political: import-competing industries are well-organized and well-informed about how they gain from trade protection, while consumers are unaware of the costs they pay.

Many concerns have been raised about the effects of globalization:• Income inequality due to the surge in imports from relatively poor countries• Offshore outsourcing