International Trade Chapter 20 11/18/2018

Objectives In this chapter, you will learn: The graphical model of comparative advantage, specialization, and the gains from trade. How differences between world prices and domestic prices prompt exports & imports. How economists analyze the economic effects of tariffs and quotas. The rebuttals to the most frequently presented arguments for protectionism. 11/18/2018

Some Key Facts Trade deficit of $782 billion in 2005. Trade surplus of services in 2005 of $58 billion Principal U.S. exports: chemicals, consumer durables, agricultural products, computers, & household appliances U.S. imports: many of the same categories of its exports: I.E. computers, chemicals, & telecommunications equipment Quantitatively, Canada is our largest trading partner U.S. has a $202 billion trade deficit with China U.S. has imported $125 billion of goods from the Middle East (mainly oil) Largest exporter in the world is Germany 11/18/2018

The Economic Basis for Trade Why nations trade hinges on three facts: Distribution of factors of production is uneven Efficient production requires different technologies or combinations of resources Products are differentiated as to quality and other nonprice attributes Labor-intensive goods Large, well-educated labor force and abundant, and therefore inexpensive, skilled labor Land-intensive goods Vast amounts of land where products such as wheat, wool, & meat can be produced inexpensively Capital-intensive goods Industrially advanced economies with relatively large amounts of capital can inexpensively produce goods whose production requires much capital 1a. Nations differ in their endowments of economic resources. 2a. As a result, Japan can produce efficiently (at low cost) a variety of labor-intensive goods such as digital cameras, video game players, & DVD players whose design & production require much skilled labor. 4a. I.E. automobiles, agricultural equipment, machinery, & chemicals. All nations, regardless of their labor, land, or capital intensity, can find special niches for individual products that are in demand worldwide because of their special qualities. The distribution of resources, technology, & product distinctiveness among nations, however, is not fixed. When that distribution changes, the relative efficiency & success with which nations produce & sell goods also changes. As national economies evolve, the size & quality of their labor forces may change, the volume & composition of their capital may shift, new technologies may develop, & even the quality of land & quantity of natural resources may be altered. As such changes occur, the relative efficiency with which a nation can produce specific goods will also change. 11/18/2018

Comparative advantage: Graphical Analysis (Fig. 20.1 pg. 393) Curves for both countries are straight lines because we are assuming constant opportunity costs Opportunity-cost ratio (domestic exchange ratio) Self-sufficiency output mix Must choose some output mix on its production possibilities curve (greatest utility) 2. See page 393 11/18/2018

Specializing based on comparative advantage Specialization & trade are mutually beneficial to the two nations Lower opportunity cost determines which product gives a comparative advantage Output increases as well Terms of trade Exchange ratio for which two products are traded (opp. Cost ratio) The case for free trade The world can achieve a more efficient allocation of resources and a higher-level of well being Promotes competition as well Links national interests & breaks down national animosities 2. Possibility of trading on these terms permits each nation to supplement its domestic production possibilities w/o trading possibilities line due to specialization. 3b. This increased competition from foreign firms forces domestic firms to find and use the lowest-cost production techniques. It also compels them to be innovative with respect to both product quality & production methods which contributed to growth 3c. Confronted with political disagreements, trading partners tend to negotiate rather than make war 11/18/2018

The case for free trade (cont) Trade barriers lessen or eliminate gains from specialization Promotes competition and deters monopoly 11/18/2018

Gains from Trade By specializing on the basis of comparative advantage a country can realize combinations of two products beyond their production possibilities. Results in a more efficient allocation of world resources and larger outputs of both products 11/18/2018

Supply & Demand Analysis of exports & imports (20.2) Amount of a good or service a nation will export or import depends on differences between the equilibrium world price and the equilibrium domestic price Domestic price – price that would prevail in a closed economy that does not engage in international trade When economies are opened for international trade, differences between world & domestic prices encourage exports or imports First…this analysis helps us understand how prices & quantities of exports & imports are determined in world markets. 11/18/2018

Supply & demand in the U.S. Domestic supply & demand set the domestic equilibrium price Any world prices above the domestic equilibrium will result in a domestic surplus of that product At prices below equilibrium, domestic shortages will result Surpluses are exported and shortages are met by importing from another country First…assume that there are no trade barriers and that Canada is the only other nation in the world, that aluminum is the product in question, and that there are no international transportation costs, to keep the analysis simple  11/18/2018

Figure 20.3 (page 398) How much aluminum will be sold in the U.S.? 100 million pounds If the world price exceeds $1, American firms will increase production and export the excess output to Canada. How much aluminum would be exported to Canada if the price was $1.25? (50) See graph b 11/18/2018

Supply & demand in Canada Domestic price is now the Canadian price If the world price is equal to the domestic (Canadian) price, no imports or exports will occur At world prices above equilibrium, Canadian firms will produce more of the product than Canadian consumers will buy The surplus will be exported At world prices below equilibrium, domestic shortages occur in Canada Imports will occur at any price below equilibrium 11/18/2018

Figure 20.4 (page 399) 11/18/2018

Equilibrium world price, exports, & imports International equilibrium occurs in this two-nation model where one nation’s import demand curve intersects another country’s export supply curve After trade, the world price will prevail in both Canada and the U.S. Only one price for a standardized commodity can persist in a highly competitive world market 11/18/2018

Figure 20.5 (page 400) How much trade is taking place between the two countries? 11/18/2018

Trade Barriers (20.3) Tariffs – excise taxes on imported goods Types of tariffs Revenue tariff – usually applied to a product that is not being produced domestically…provides revenue to federal government Protective tariff – shield domestic producers from foreign competition. Puts foreign competitors at a competitive disadvantage in a domestic market First…no matter how compelling the case for free trade, barriers to free trade do exist. 11/18/2018

Other types of trade barriers Import quota Maximum amount of a commodity that may be imported Nontariff barrier Licensing requirement that specifies unreasonable standards pertaining to product quality & safety or… Unnecessary bureaucratic red tape that is used to restrict imports Voluntary export restriction (VER) Foreign firms “voluntarily” limit the amount of their exports to a particular country They do this in the hope of avoiding more stringent trade barriers 11/18/2018

Economic impact of tariffs A tariff that increase the price of a good will reduce domestic consumption Domestic producers will be able to sell more output at a higher price Foreign producers will sell less output Direct effects Indirect effect Figure 18.6 4. Decline in consumption, increased domestic production, decline in imports, & tariff revenue 5. Since the other country is not able to sell as much to us, they have less money to buy our exports…tariffs directly promote the expansion of inefficient industries that do not have a comparative advantage…put bluntly, tariffs cause resources to be shifted in the wrong direction. 11/18/2018

Economic impact of quotas Same economic impact as a tariff with one big difference: Tariffs generate revenue for the domestic government, a quota transfers that revenue to foreign producers For consumers in the U.S., a tariff produces a better economic outcome than a quota, other things being the same 1b. A tariff generates government revenue that can be used to cut other taxes or to finance public goods & services that benefit the U.S. In contrast, the higher price created by quotas results in additional revenue for foreign producers 11/18/2018

Net costs of tariffs & quotas Cost to consumers substantially exceeds the gains to producers & government Also, industries employ large amounts of economic resources to influence Congress to pass & retain protectionist laws Result is economic inefficiency 11/18/2018

The Case for Protection Military self-sufficiency argument Preserve or strengthen industries that produce the materials essential for national defense In an uncertain world, political objectives sometimes must take precedence over economic goals Infant industry argument Protective tariffs are needed to allow new domestic industries to establish themselves Counterarguments Which industries are new? Direct subsidies may be better Strategic trade policy – retaliation could occur from countries that are required to pay tariffs to us First…despite the logic of specialization & trade, there are still protectionists in some union halls, corporate boardrooms, & the halls of Congress. What arguments do protectionists make to justify trade barriers? How valid are those arguments? 2c. Outcome…higher tariffs worldwide, reduction of world trade, & loss of potential gains from technological advances 11/18/2018

Diversification for Stability Argument Highly specialized economies are dependent on international markets for their income Export revenues can decline greatly for various reasons (war, recessions abroad, etc.) Tariff & quota protection is allegedly needed in these nations to enable greater industrial diversification This argument has little or no relevance to the U.S. or other advanced economies. 11/18/2018

Protection-against-dumping argument Tariffs are needed to protect domestic firms from “dumping” by foreign producers The selling of excess goods in a foreign market at a price below cost Why? Dumping abroad drives out domestic competitors there, thus obtaining monopoly power May be a form of price discrimination (charging a higher price at home and a lower price abroad) Most nations prohibit dumping (unfair trade practice) 11/18/2018

Increased domestic employment argument Reducing imports will divert spending on another nation’s output to spending on domestic output. Shortcomings: while imports may eliminate some U.S. jobs, it creates others (alters the composition of employment but volume of employed workers does not change much) Cheap foreign Labor Argument Domestic firms & workers must be shielded from competitors in countries where wages are low 11/18/2018

Offshoring Shifting work previously done by American workers to workers located in other nations World Trade Organization Oversees trade agreements & rules on disputes relating to them. 11/18/2018