Gaining from International Trade Chapter 18

Chapter 18 Objectives Comprehend why specialization and trade generate gains. Describe the kinds of trade barriers and their effects. Recognize reasons for implementing trade restrictions. Clear up common misconceptions of international trade.

The Growth of the U.S. Trade Sector Imports (% of GDP) 20 15 10 As is shown here, both exports & imports have grown substantially as a share of the U.S. economy during the last several decades. Their growth has accelerated since 1980. Reductions in both transportation and communication costs, as well as lower trade barriers have contributed to this growth. 5 1960 1970 1980 1990 2000 2010 Exports (% of GDP) 20 15 10 5 1960 1970 1980 1990 2000 2010

Leading Trade Partners of the U.S.

Trade and Comparative Advantage Comparative advantage – the ability to produce a good at a lower opportunity cost than others. Relative costs determine comparative advantage As long as relative costs differ, gains from trade are possible!

Absolute Advantage Absolute advantage – a nation can produce more of a good (with the same amount of resources) than another nation Trade isn’t based on absolute advantage for individuals or countries

Opportunity Cost Jessica can gain if specialize in Fish Output Per Day Fish Apples Jessica 50 OR Winston 100 200 Opportunity Costs Of 1 Fish Of 1 Apple Jessica 1 Apple 1 Fish Winston 2 Apples ½ Fish Jessica can gain if specialize in Fish Winston can gain if specialize in Apples

Jessica’s PPC: No Trade Jessica decides to make 25 fish and 25 apples 50 Apples 25 25 50 Fish

Winston’s PPC: No Trade Winston decides to make 50 fish and 100 apples 200 Apples 100 50 100 Fish

They Decide to Trade! Production Jessica specializes in fish: 50 fish, 0 apples Winston specializes in apples: 25 fish, 150 apples Their agents and lawyers talk and it’s mutually agreed that the two will trade 37 apples for 25 fish Consumption Jessica consumes: 25 fish, 37 apples Winston consumes: 50 fish, 113 apples

Jessica’s Consumption Possibilities Curve 74 50 Apples 37 25 25 50 Fish

Winston’s Consumption Possibilities Curve 200 Apples 113 100 50 100 270 Fish

Law of Comparative Advantage Trade between nations leads to An expansion in total output Gains for each trading partner Higher incomes for both nations

Gains from International Trade 1. Gains from large-scale production 2. Gains from more competitive markets 3. More pressure to adopt sound institutions

World Price > Domestic Price If the world price is higher than the domestic price, the domestic country has a comparative advantage in producing the good The domestic country as a whole will benefit if they export the good

World Price > Domestic Price No Trade Outcome Consumer Surplus Price S World Price Producer Surplus Price w/o trade D Quantity Equilibrium Quantity

World Price > Domestic Price Trade Outcome Consumer Surplus Price S Price w/ trade World Price Producer Surplus D Quantity Quantity Consumed Quantity Produced Amount Exported

World Price > Domestic Price Trade Outcome Total gains from Trade! Price S Price w/ trade World Price D Quantity Quantity Consumed Quantity Produced Amount Exported

Impact of Exporting Domestic price will rise to world price Domestic producers of the good  winners  Domestic consumers of the good  losers  Country overall  gains to producers are greater than losses to consumers! 

World Price < Domestic Price If the world price is less than the domestic price, another country has a comparative advantage in producing the good The domestic country will benefit if they import the good

World Price < Domestic Price No Trade Outcome Consumer Surplus Price S Producer Surplus Price w/o trade World Price D Quantity Equilibrium Quantity

World Price < Domestic Price Trade Outcome Consumer Surplus Price S Producer Surplus Price w/ trade World Price D Quantity Quantity Consumed Quantity Produced Amount Imported

World Price < Domestic Price Trade Outcome Total Gains From Trade! Price S Price w/ trade World Price D Quantity Quantity Consumed Quantity Produced Amount Imported

Impact of Importing Domestic price will fall to world price Domestic producers of the good  losers  Domestic consumers of the good winners  Country overall  Winners! Gains to consumers are greater than losses to producers But producers’ losses are visible Consumers gains are harder to see

Trade Openness, Income, and Growth 10 Most Open Economies, 1980-2002 2005 GDP per capita 1980-2005 Growth rate TOI Hong Kong 10.0 $ 30,989 3.9 % Singapore 9.9 $ 26,390 4.3 % Bahrain 8.6 $ 19,112 1.0 % Belgium 8.6 $ 28,575 1.7 % Malaysia 8.6 $ 9,681 3.6 % The income levels and growth rates of the ten most and ten least open economies (as measured by the Trade Openness Index – TOI) are displayed here. Note that more open economies both achieved higher income levels and grew more rapidly. U.S. ranked 16th Luxembourg 8.5 $ 53,583 3.7 % Netherlands 8.4 $ 29,078 1.6 % Taiwan 8.4 $ 20,868 5.1 % Ireland 8.1 $ 34,256 4.5 % Australia 7.9 $ 29,981 1.9 % Average: 8.7 $ 28,251 3.1 % 10 Least Open Economies, 1980-2002 2005 GDP per capita 1980-2005 Growth rate TOI India 4.3 $ 3,072 4.0 % Tanzania 4.1 $ 662 2.3 % Egypt 4.1 $ 3,858 2.5 % Pakistan 3.9 $ 2,109 2.4 % Syria 3.8 $ 3,388 0.6 % Algeria 3.4 $ 6,283 0.5 % Sierra Leone 3.4 $ 717 - 1.1 % Burundi 3.0 $ 622 - 1.0 % Sources: TOI data are from Charles Skipton, The Measurement of Trade Openness. Doctoral Dissertation, Florida State University, 2003. Per capita GDP & growth data are from The World Bank, World Development Indicators, CD-ROM, 2004. Iran 2.9 $ 7,089 1.1 % Bangladesh 2.5 $ 1,827 2.2 % Average: 3.5 $ 2,963 1.4 %

Economics of Tariffs Tariff – a tax levied on goods imported into a country Smoot-Hawley Tariff Act 1930 – 60% 2008 – 4% Benefits domestic producers and government Hurts domestic consumers! Causes deadweight loss Encourages lobbying by domestic producers

Economics of Quotas Import quota – a specific limit or maximum quantity of a good permitted to be imported into a country during a given period U.S.: peanuts, sugar, brooms, shoes Benefits domestic and some foreign producers Hurts domestic consumers! Causes deadweight loss Encourages lobbying by producers

Trade Restrictions Create special interest groups Prevent voluntary exchanges Reduce overall output, cause deadweight loss

Arguments Against Free Trade If trade is good, why to nations adopt restrictions? Arguments Against Free Trade National-Defense Infant-Industry Antidumping Politics of Trade Restrictions

National Defense Argument Trade Opponents Say: Certain industries are vital to our national defense Reality: This argument is often abused Government could buy and store resource during peacetime Economic growth is part of a strong defense

Infant-Industry Argument Trade Opponents Say: New domestic industries just need a chance to develop Reality: Once protection is granted, difficult to remove Over 100 years ago sugar quotas, manufacturing tariffs, and steel tariffs were put into place

Antidumping Argument Trade Opponents Say: Foreign producers will cut prices to drive out competition, then use power to gouge consumers Reality: Firms can re-enter industry Competition keeps prices low Dumping – selling a good in a foreign country at a lower price than it’s sold for in the domestic market

Special Interests Trade restrictions provide visible benefits for a few while spreading the costs over many U.S. tariff code 3,091 pages High tariffs on some goods Low tariffs on others Confusing to understand Very costly to administer!

Trade Truth Cannot decrease imports w/o decreasing demand for exports Reason: Tariffs and quotas cause $ to appreciate This makes exports fall

Trade Fallacies Myth: Trade restrictions that limit imports save jobs Truths: Trade restrictions increase employment in protected industries Trade restrictions destroy jobs in domestic sectors that export Trade restrictions hurt domestic consumers and producers via higher prices Restrictions reshuffle jobs, reduce incomes

Trade Fallacies Myth: Free trade with low-wage countries will reduce U.S. wages Truths: Lower prices increase consumers’ purchasing power Source of wage difference is productivity difference Trade between a doctor and a housekeeper doesn’t lower doctor’s wages!

Global Trade World Trade Organization (WTO) New name for GATT in 1994; Responsible for monitoring trade agreements among 153 member countries Average tariff rate fell from 40% in 1947 to 3% North American Free Trade Agreement (NAFTA) 1994 trade agreement among U.S., Canada and Mexico Eliminated most tariffs

Chapter 18 Objectives Comprehend why specialization and trade generate gains. Describe the kinds of trade barriers and their effects. Recognize reasons for implementing trade restrictions. Clear up common misconceptions of international trade.