Chapter 8 International Trade

Introduction In this chapter we… Examine why trade is beneficial. Use the supply and demand model to analyze trade. Evaluate political and economic arguments that free trade is not necessarily good.

Why Trade? Three benefits of trade It allows for division of knowledge. It allows economies of scale and creates greater competition. It increases wealth through the principle of comparative advantage. Let’s look at each of these in turn.

Why Trade? Division of Knowledge—Specialization In a modern economy—more knowledge is used than can reside in a single brain. Specialization →↑ knowledge → ↑productivity Without trade, specialization is not possible. Trade connects all markets. Example: Dog walkers, closet organizers give physicians the time to perfect their skills. Trade → ↑markets → ↑division of knowledge Entrance of China, Eastern Europe, and Russia into world markets → ↑ stock of engineers, scientists → ↑ available knowledge Instructor Note: Division of knowledge and specialization are the same. The point of specialization is that it increases the total amount of knowledge available to everyone. The phrase “everyone knows everything” is applicable here. The fall of the Berlin wall and the collapse of the Soviet Union opened these economies to trade. This in effect made the knowledge and skills available in these countries available to the world market. The opening of China to trade did the same thing for Chinese skills and knowledge. The critical point is that this increased division of knowledge.

Why Trade? Economies of Scale and Creating Competition Economies of Scale—Larger scale production reduces costs. Trade → ↑specialization → larger scale production → economies of scale. Example: Forming the EU → ↑specialization → larger firms → ↓ prices → EU firms become more competitive in the world market.

Why Trade? Economies of Scale and Creating Competition (cont.) Trade Creates Competition Example: 1980s export restraints by Japanese → ↓ Imports of Japanese cars → Price of Japanese cars ↑ by $1,300 Price of American cars ↑ by $660. International competition keeps domestic firms competitive and on their toes. Threat of foreign competition keeps domestic prices down.

Why Trade? Comparative Advantage A country has a comparative advantage in producing goods for which it has the lowest opportunity cost. Allows both trading partners to benefit from trade. Not to be confused with absolute advantage. The ability to produce the same good using fewer inputs than another producer.

Why Trade? Comparative Advantage (cont.) U.S. requires less labor to produce both → absolute advantage in producing both. Shirts: Opportunity cost is lowest in Mexico. Computers: Opportunity cost is lowest in U.S. Comparative advantage Computers: United States Shirts: Mexico

Why Trade? Comparative Advantage (cont.) The theory of comparative advantage says that total production of the two countries will be greatest if both countries: Produce what they have a comparative advantage in. Import the other goods they want. In this case Mexico will produce shirts and the U.S. will produce computers. Let’s see how this works with some further calculations.

Why Trade? Comparative Advantage (cont.) With No Trade—Suppose U.S. and Mexico allocate the same amount of labor (12 units) to the production of each good. Instructor Note: Because it requires 12 units of labor to produce one computer in Mexico, allocating 12 units of labor to producing computers yields 1 computer. It requires 2 units of labor to produce a shirt in Mexico. Allocating 12 units to the production of shirts yields 6 shirts. Because it requires 1 unit of labor to produce both 1 computer and 1 shirt, allocation 12 units of labor to each yields 12 computers and 12 shirts. Combining the output of both goods for each country, we see that the total output of computers and shirts is 13 and 18.

Why Trade? Comparative Advantage (cont.) Suppose Mexico completely specializes in producing shirts and the U.S. moves 2 units of labor from producing shirts to computers. Instructor Note: Because it requires 2 units of labor to produce one shirt in Mexico, allocating 0 units of labor to producing computers and 24 units to shirts yields 0 computers and 12 shirts. Because in the U.S. it requires 1 unit of labor to produce both goods allocating 14 units of labor to computers and 10 units of labor to shirts yields 14 computers and 10 shirts. Total production of computers between the two countries increases by 1 (14-13) and the total production of shirts increases by 3 (22 – 18). The next slide will show how trade will allow both countries to be better off. Note: Total production of the two goods is higher than without specialization.

Why Trade? Comparative Advantage (cont.) With specialization, trade can make both countries better off. U.S. trades one computer for 3 shirts. Instructor Note: Specialization increases total output of both goods. With specialization trade the United States has one more computer (13 -12) and Mexico has three more shirts (9 – 6) Trade allows each country to share the increase in output, making them both better off. Note: With trade both countries are better off, even though the U.S. has an absolute advantage in both goods.

Why Trade? Comparative Advantage (cont.) Comparative Advantage and Wages Assume that computers sell for $300 and shirts sell for $100 (consistent with the 3 to one trade). Average wage in each country can be calculated by using: Let’s use this calculation to see how specialization and trade affects wages. Instructor Note: The assumption is that labor can produce either computers or shirts. Therefore, there will be an average wage for each country. The assumed prices are not known so any values will work as long as their ratio is the one assumed in the previous trade ratio. In this case it is 3 shirts for one computer.

Why Trade? Comparative Advantage (cont.) Comparative Advantage and Wages (cont.) Without Trade With Trade and Specialization Instructor Note: The point here is that even though wages are much lower in Mexico, both countries are better off with specialization and trade. Even though wages are much lower in Mexico, trade and specialization increases wages in both countries. Note: Trade and specialization increases wages in both countries

Why Trade? Comparative Advantage (cont.) Adam Smith on Trade It is the maxim of every prudent master of a family never to attempt to make at home what it will cost him more to make than to buy. The tailor does not attempt to make his own shoes, but buys them of the shoemaker. The shoemaker does not attempt to make his own clothes, but employs a tailor. What is prudence in the conduct of every private family can scarce be folly in that of a great kingdom. If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry employed in a way in which we have some advantage. Instructor Note: This is an optional slide. The fact that Adam Smith wrote it more than 200 years ago shows that the principle of comparative advantage and the gains from trade have been known for a long time. While the economics has been settled for a long time, the politics of trade has not.

What does specialization do to productivity? Why? How does trade let us benefit from the advantages of specialization? Alex Rodriguez is a very good baseball player. He is probably also good at mowing his lawn. Why would Alex Rodriguez pay someone else to mow his lawn rather than do it himself?

Analyzing Trade with Supply and Demand We now use the demand and supply model to determine… The effects of unrestricted trade on... Domestic equilibrium price and quantity. Imports The effects of tariffs and quotas on the… Let’s turn to the model.

Analyzing Trade with Supply and Demand w/ Free trade: World price prevails. Domestic consumption = Domestic production = Price Domestic supply imports = No trade equilibrium P no trade Free trade equilibrium World price World supply Instructor Note: This is an animated diagram so you can explain as you “draw”. We are using the “small country” assumption which implies that semiconductors can be imported at a constant price. That is, our demand for semiconductors is small relative to the world market so we can import all be want without affecting the world price. The level of imports is determined by the difference between domestic demand and domestic production at the world price. The lower the world price relative to the domestic “no trade” price the greater will be imports. Domestic consumption Domestic demand Imports Quantity of semiconductors Domestic production

Analyzing Trade with Supply and Demand With Tariff: World price + tariff prevails. ↓Domestic consumption → ↑Domestic production → Price Domestic supply ↓imports → tariff revenue Equilibrium w/tariff pno trade World supply + tariff World price + tariff tariff World price Instructor Note: This is an animated diagram so you can explain as you “draw”. With the tariff the world supply curve shifts up by the amount of the tariff per unit. The price domestic consumers pays goes up by the amount of the tariff and domestic consumption falls. The price domestic producers pay also goes up to domestic production rises. Results: Imports are less and domestic prices are higher Domestic producers win while domestic consumers lose. The government gains tariff revenue. World Supply ↓ Domestic consumption Domestic demand Imports w/ free trade Quantity of semiconductors ↑Domestic production Imports w/tariff

The Costs of Protectionism To simplify we make two assumptions: Tariff eliminates all imports. With free trade, domestic production = zero. Reasonable approximations for sugar. A tariff has two effects: ↑ domestic production, ↓ domestic consumption. Resources are drawn away from more productive uses to produce sugar. Less is consumed → lower gains from trade. Let’s turn to our model again. Instructor Note: Saving jobs through trade restrictions sounds good and is often politically rewarding. The problem is that the productive higher paying jobs that fail to be created are not always as visible as the jobs “saved”. This is one of the fundamental difficulties in debating trade politics. The gains from trade restrictions are seen and the losses are often not seen.

The Costs of Protectionism Wasted resources and lost gains from trade. Price per pound (in cents) Domestic demand Domestic supply World supply + tariff 20 Tariff equilibrium U. S. costs Lost gains from trade or deadweight loss Value of wasted resources World price World supply Instructor Note: This is an animated diagram so you can explain as you “draw”. Imposing a tariff on sugar raises the domestic price from 9 cents/lb. to 20 cents/lb.. Because domestic producers did not produce sugar at the world price of 9 cents/lb, the tariff increased producer surplus by the entire area under the world supply + tariff and above the domestic supply curve. With the tariff, consumer surplus is reduced by the amount of area below the domestic demand curve between world price and the world price + the tariff . Because the loss to consumers is greater than the gain to producers, there is a net loss to the economy. This loss is divided into two parts: The value of wasted resources resulting from producing sugar rather than other goods where the resources would be more productive. These costs are largely unseen and therefore often left out of the political debate. The lost gains from trade is lost consumer surplus resulting from consumers paying more for sugar. These costs are visible but spread among millions of consumers. Because the cost per consumer is small, these costs are not likely to get much political attention. These losses are quantified in the next diagram. 9 Free trade equilibrium World costs 20 24 Quantity (in billions of pounds)

The Costs of Protectionism Wasted resources and lost gains from trade. (cont.) Price per pound (in cents) Domestic demand Domestic supply World supply + tariff 20 Value of wasted resources = [(.20 – .09) x 20]/2 = $1.1 billion Lost gains from trade = [(.20 - .09) x (24 – 20)]/2 = $.22 billion $1.1 billion World price World supply Instructor Note: This is an animated diagram so you can explain as you “draw”. 9 20 24 Quantity (in billions of pounds)

The Costs of Protectionism Conclusions A tariff reduces economic efficiency because… The supply of goods is no longer sold by the sellers with the lowest costs. Because world suppliers are willing to sell for less, and U.S. consumers are willing to pay more → mutually profitable gains from trade are prevented by law. U.S. consumers pay more, and workers in other countries (e.g., Brazil), many of whom are poor, lose income.

The Costs of Protectionism One final cost: lobbying The loss to domestic consumers is greater than the gains to domestic producers. Why then does congress pass tariffs? Small number of producers → Benefit per producer is high Large number of consumers → Loss per consumer is low. Result: return from lobbying to producers is higher than for consumers. Lobbying diverts resources from more productive activities.

Who benefits from a tariff? Who loses? Why does trade protectionism lead to wasted resources? If there are winners and losers from trade restrictions, why do we hear more often from the people who gain from trade restrictions than from the people who lose?

Arguments Against International Trade Most Common Arguments Trade reduces the number of jobs in the U.S. It’s wrong to trade with countries that use child labor. We need to keep some industries for reasons of national security. We need to keep some “key” industries because of beneficial spillovers onto other sectors. We can increase U.S. well-being with strategic trade protectionism. Let’s look at each of these in turn.

Arguments Against International Trade Trade and Jobs Tariffs raise the price of protected goods. Consumers have less money to spend on other goods. Jobs are lost in other industries—these lost jobs are hard to see. Increased imports into the U.S. result in higher exports from the U.S. The U.S. dollars we spend on other country’s good are used to buy our goods. Jobs are created in U.S. exporting industries.

Arguments Against International Trade Child Labor Restricting imports made by child labor may do more harm than good. Children work out of necessity—what else will they do? Often the alternative is worse. Prostitution Scrounging in refuse dumps Child labor is a poverty problem not a trade problem. The next figure shows this.

Arguments Against International Trade Instructor Note: The size of the circles is proportional to the total number of child laborers. The vast majority of working children live in countries with a real GDP per capita less than $5,000. Countries with real GDP per capita less than $1,000 have more than thirty percent of their children in the labor force.

Arguments Against International Trade Trade and National Security Some industries probably should be protected. Subject to great abuse—almost every industry can make this argument for protection. Examples: Vaccine production?—probably a good idea. Mohair?—are you kidding?

Arguments Against International Trade Key Industries Some industries are characterized by large spillovers to other industries Example: Computer chips are always used in some other product. Protection benefits a larger number of firms. Two comments: Subsidy is a better option than a tariff. Hard to determine which industries are key.

Arguments Against International Trade Strategic Trade Protectionism Government helps domestic firms act like a cartel when they sell to international buyers. May be able to grab a larger share of the gains from trade than with free trade. This can be done either with a… Tax on exports Quotas on exports Success is limited by the number of available substitutes. OPEC succeeds because oil has few substitutes.

Over the past 30 years, most U. S Over the past 30 years, most U.S. garment manufacturing has moved overseas, to places such as India and China, where wages are lower. The result of this shift has been a sizeable drop in the number of garment workers in the United States. While bad for these workers, why has this trend been a net benefit for the United States?

What would happen if the U. S What would happen if the U.S. government decided that computer chip manufacturing was a strategic national industry and provided monetary grants to Silicon Valley companies? Trace the effects of this policy on Silicon Valley companies, foreign competitors, the world market for computer chips, and the cost and benefit to U.S. consumers as a whole.

Trade and Globalization Globalization is not new Roman Empire Revitalized trade routes → European Renaissance “globalization is the advance of human cooperation across national boundaries.” (Donald Boudreaux) Periods of increased trade and the spread of ideas have been among the best for human progress.

Takeaway Specialization and trade create enormous increases in productivity. Increases the total sum of knowledge. Takes advantage of economies of scale. Comparative advantage—when a country can produce something at a lower opportunity cost. Every person and every country has a comparative advantage in something. Restrictions on trade waste resources. Consumers lose more than producers gain.

Takeaway Wages are determined by productivity. High productivity countries → high wages. Low productivity countries → low wages. Trade raises wages in both countries. We have looked at five arguments for protectionism. Some are valid but have limited applicability. Globalization is not new. Human progress has accelerated when countries have become more connected with trade.