Trade Policy Exports stood at 38% of GDP in 2007 Foreign affiliates account for roughly 50% of manufacturing output and Canadians have significant investment abroad Most international transactions are with the U.S. (84% of exports are to the U.S. and the U.S. has 64% of the foreign direct investment in Canada) The Canadian economy is strongly integrated into the world economy

Gains from trade Comparative advantage Economies of scale Increased competition –When markets are imperfectly competitive, international trade will increase competition which leads to lower prices and a reduction in deadweight loss. –The “disciplining hand” of greater competition can “weed out” inefficient firms and induce firms to work harder to increase productivity. –One researcher estimates that Canadian tariff reductions under the Canada-U.S FTA increased value-added per worker by 0.6 percent per year from 1988 to For highly impacted industries, the top third in terms of tariff cuts, the annual effect was 3.2 percent.

Canada has embraced free trade Canada is a member of the World Trade Organization and has signed free trade agreements with the United States (1988), Mexico (1993), Israel (1997), Chile (1997), and Costa Rica (2001). Free trade with the U.S. has created substantial trade.

FTA Tariff Effects on Exports Source: strategis.ic.gc.ca, Lester and Morehen (1987)

FTA Tariff Effects on Imports

Mfg employment, Canada (1991=100)

Import restricting policies Tariffs Quotas: A quota is a fixed limit on the quantity of imports. Quotas are illegal under the General Agreement on Tariffs and Trade. Non-tariff barriers –Administrative barriers: administrative procedures that make it more difficult (and costly) for exports. –Regulatory barriers: These include consumer health and safety regulations and technical standards. –Government procurement policies

Import tariff domestic supply P* P*+t Import supply domestic demand w xy z A BCD Impact of an import tariff

Quota domestic supply P* P*+e Import supply domestic demand w xy z A BCD Impact of a quota quota

Trade policies under perfect competition Under perfect competition, tariffs and quotas reduce welfare and redistribute wealth.

Normative rationales for trade policy Revenue: (2% for Canada) Non-economic: national defense, culture Profit shifting Infant industry protection Increasing employment

Imperfect competition and rent-shifting Economic rents (profits in excess of "normal" returns to factors) may exist in imperfectly competitive industries. Governments naturally desire that industries with economic rents reside within their borders and institute policies to promote these industries.

Imperfect competition and rent-shifting Airbus BoeingEnterNot enter Enter-5, -5100, 0 Not enter0, 1000, 0 Airbus given subsidy of 10 Airbus BoeingEnterNot enter Enter-5, 5100, 0 Not enter0, 1100, 0 Initial situation

Infant Industry Protection A government may need to promote industries when market failures prevent valuable industries from emerging. The idea behind infant industry protection is that a new industry needs time to move down the learning curve and attain production efficiency

Infant Industry Protection (1) The country may have comparative advantage for producing the good (2) Consumers can save transportation costs (3) The industry may confer positive externalities (such as national defense or knowledge spillovers to related industries). Note that efficient capital markets would finance the industry in the case of (1) and (2). Thus, market failure--imperfect capital markets or externalities--must exist if infant industry protection is justified. Why would a nation prefer to have its own industry as opposed to importing the good from abroad?

Protecting industries (1) Industries using protected industry's product as input face higher prices. (2) Workers will be drawn into protected industry and out of other industries. (3) Other countries may retaliate and protect their own industries. Policies that promote one sector of the economy will likely have harmful effects on other sectors:

Protecting industries (4) Protection can lead to appreciation: Protection (say, a tariff) reduces the amount of foreign goods bought by Canadians. Thus, there will be fewer Canadian dollars supplied in foreign exchange markets and the Canadian dollar will appreciate. Appreciation will raise the cost of Canadian goods to foreigners and harm export industries.