Today: Winners and losers of various international trade policies

Previously, we talked about… How trade can benefit people Comparative advantage being the core of beneficial trade An introduction of international trade

Today: More on international trade Review of comparative advantage Examining consumption possibilities Without trade With trade Supply and demand analysis of trade Tariffs and Quotas “Outsourcing”

Review of comparative advantage Recall the principle of comparative advantage “Everyone does best when each person (or each country) concentrates on the activities for which his or her opportunity cost is lowest.” (F/B p. 39) Today, we will apply this concept on a countrywide scale

Comparative advantage: Same numbers, different names Productivity in pizza production Productivity in salad production United States 20 pizzas cooked per hour 10 salads made per hour Chile 16 pizzas cooked per hour 4 salads made per hour

Comparative advantage Opportunity cost of cooking a pizza Opportunity cost of making a salad U.S. ½ salad 2 pizzas Chile ¼ salad 4 pizzas Recall: To find comparative advantage for each person, find the lowest number in each column

Recall increasing opportunity cost Opportunity cost increases as production increases within each country Each country uses its best pizza maker to make its first pizzas Then, the next best pizza maker is used, etc. The same applies to salads

Production possibilities curve Recall from last lecture that all of the points along PGQ are the efficient points of the production possibilities curve Recall that this shape occurs due to increasing opportunity costs as more is produced

Production possibilities curve Without trade, only points along arc PGQ (or points between this arc and the origin) can be consumed We will see that gains can be made by trade

The world market In the world market, there is an equilibrium price (based on world supply and world demand) Any one country that enters or exits the market usually does not change the market price much For ease of discussion, assume that entry or exit by any one country does not change the world price

Consumption possibilities curve If we produce at point G, we can trade goods at the given market price Production at G (with trade)  Consumption anywhere along FGH

Which consumption possibility curve is best? We could produce at one of the red dots before we start trading However, note that there are fewer consumption sets possible than producing at G

Optimal production in an open economy Since the red line is suboptimal, we will not utilize it Similarly, any point except G will produce a similar result to the red line Suboptimal consumption possibilities for any production except G

Optimal production in an open economy Solution Produce such that the “line of trade possibilities” is tangent to the production possibilities curve In this case, point G is tangent to line FGH

Supply and demand analysis of trade As we just analyzed, we saw that total surplus goes up when world trade is possible However, we will see that there are winners and losers to trade Note that the winners’ gain is larger than the losers’ loss

Market for cars, w/o trade Suppose that without trade, 40,000 cars are sold at a price of $14,000

Market for cars, w/o trade Consumer surplus is blue shaded area Producer surplus is red shaded area

Market for cars, with trade Notice that the world price for cars is $10,000 At this price, notice that 20,000 cars will be supplied and 60,000 cars will be demanded in this market

Market for cars, with trade What will happen? This is unlike the case of rent control, since the shortage is picked up by the world market 20,000 domestic cars will be purchased 40,000 foreign cars will be purchased Imports

Surplus with trade Consumer surplus increases substantially Producer surplus decreases, but does not change as much as consumer surplus does Imports

Without imports (left) With imports (right)

Net gain Imports

A similar exercise can be done for a country that is a net exporter When a country is a net exporter, the world price is above what it would be if trade was not possible Consumer surplus decreases when trade occurs Producer surplus increases when trade occurs Overall, total surplus increases

Tariffs, quotas, and bailouts Even when trade is not prohibited, countries use other devices to control the amount of a particular good imported Tariff Tax that must be paid for each unit of the good imported Quota A binding limit set on the amount of a good that can be imported Bailouts: An example with U.S. automakers Subsidized loans See additional reading on class website

What happens when we impose a tariff? In this case, the tariff imposed is $1000 per ton of sugar imported We will see that some potential economic surplus is lost when the tariff is imposed

What happens when we impose a tariff? Total surplus without tariffs Shaded area

What happens when we impose a tariff? With a tariff, the price paid by consumers is the world price plus the amount of the tariff Think of a tariff just like a tax This increases the quantity supplied domestically and decreases the amount imported

What happens when we impose a tariff? Quantity supplied domestically increases Imports decrease Before, 100 tons minus 20 tons, or 80 tons After, 80 tons minus 40 tons, or 40 tons

Total surplus and tariff money collected Consumer surplus (CS) Producer surplus (PS) Tariff revenue generated What is missing?

Total surplus and tariff money collected CS PS Tariffs What is missing? Two triangles are lost with the imposition of tariffs

Total surplus and tariff money collected The two triangles lost are potential surplus that could be gained Notice that relative to open global trade, producer surplus is higher Consumer surplus is lower with the tariff (relative to open global trade)

Voluntary export restraints (VERs) Many American consumers bought fuel-efficient Japanese cars 1980s VERs agreed to between US and Japan U.S. auto makers benefited by decreased competition Japanese auto makers benefited by being able to raise their prices U.S. consumers lost by having to pay more for all cars purchased

VERs VERs are a type of quota What does economic theory tell us about quotas?

Quotas Quotas are similar to tariffs, except: Domestic supply plus quota determines supply available in a country’s market Equilibrium in this example is price of 125, 80,000 TV’s

What else is different with quotas? With quotas, no revenues are directly generated Those with right to import and export gain economic rents

The U.S. automaker bailout Bad decision making CAFE standards What did fuel economy standards lead to? Minivans SUVs Bankruptcy for some U.S. automakers in the near future? See http://www.forbes.com/opinions/2008/10/07/bailout-election-michigan-oped-cx_tc_1008cooley.html

“Outsourcing” “Outsourcing” has been a controversial term in the media in recent years There are definitely short-run costs of outsourcing Displaced workers Buildings and machinery that gets unused

“Outsourcing” Long-run benefits of outsourcing Each country can specialize what it has comparative advantage in Technological improvements lower the costs of trade Lower costs to consumers

How to make sure your job does not get outsourced Make sure it requires a lot of face-to-face contact Construction work Automobile repair Health care Make sure that you have skills that nobody else has

Final thoughts about “outsourcing” Trade policy can be formed such that those that are displaced are not any worse off Some of the gains from “making the pie bigger” can be transferred to those that get displaced Justification for re-training programs for displaced workers Overall, the standard of living of a country improves with trade Example: Think how much bananas would cost if we could not import them

Summary Trade improves overall surplus Some people win, while others lose Trade barriers, such as protectionism, quotas, and tariffs limit the gains from trade Outsourcing has short-run costs but long-run benefits in a country’s economy

Upcoming attractions For the next month, we will examine market failures and some economic fields Market failures: Monopoly, oligopoly, monopolistic competition, externalities, cost of information, private provision of public goods Fields Some potential topics: Labor, Income distribution, Environment, Health/Safety, Public Good analysis

End of Unit 3 Starting next week, Unit 4 Monopoly, including profit maximization and inefficiencies Game theoretical tools needed to analyze small groups of people or firms Applications, including Prisoner’s Dilemma Study of externalities