Lecture Notes: Econ 203 Introductory Microeconomics Lecture/Chapter 9: International Trade M. Cary Leahey Manhattan College Fall 2012

2 Goals This is another applications chapter looking at international trade. This chapter reviews many of the concepts introduced in earlier classes, particularly the tradeoff between efficiency and equity. This chapter will examine the determinants of trade-why and how much does a country import or export. We also look at who benefits and loses from trade. Do the gains outweigh the benefits At the end, we review the merits of a number of well-known arguments for restricting trade.

3 Comparative advantage and the “world price” Comparative advantage unfolds if a country produces the good at a lower opportunity cost than other countries. Nations gains from trade by exporting the goods that they have a comparative advantage. Armed with this knowledge, let us make some assumptions: Pw = the world price of a good, one that prevails in world markets Pd = domestic price without trade If Pd < Pw, then the country has a comp advantage and exports If Pd > Pw, then the country imports the goods Assuming all countries are “small,” they are price takers and for them Pw is the only relevant price No seller would accept less than Pw No buyer would pay more than Pw

Example 1: a country that exports soybeans Without trade, P D = $4 Q = 500 P W = $6 Under free trade, –domestic consumers demand 300 –domestic producers supply 750 –exports = 450 P Q D S $6 $ Soybeans exports 750

Example 1: a country that exports soybeans Without trade, CS = A + B PS = C Total surplus = A + B + C With trade, CS = A PS = B + C + D Total surplus = A + B + C + D P Q D S $6 $4 Soybeans exports A B D C gains from trade

Without trade, P D = $3000, Q = 400 In world markets, P W = $1500 Under free trade, how many TVs will the country import or export? What about the gains from trade? P Q D S $ $ Plasma TVs Example 2, a country that imports TVs

Under free trade,  domestic consumers demand 600  domestic producers supply 200  imports = 400 P Q D S $ $ Plasma TVs imports Example 2, a country that imports TVs

Without trade, CS = A PS = B + C Total surplus = A + B + C With trade, CS = A + B + D PS = C Total surplus = A + B + C + D P Q D S $1500 $3000 Plasma TVs A B D C gains from trade imports Example 2, a country that imports TVs

total surplus producer surplus consumer surplus direction of trade rises falls rises imports P D > P W rises falls exports P D < P W Summary of the welfare effects from trade Whether a good is imported or exported, trade creates winners and losers. But the gains exceed the losses.

10 International trade: other benefits and costs Other benefits: Consumers enjoy increased access to more and different goods. Producers can target a large market and achieve lower costs working at a larger scale. Foreign competition may reduce domestic firms’ market power, increasing total societal welfare. Trade enhances information flow and the spread of technology. Costs: While the winners can compensate the losers and everyone can be better off, this rarely happens in the “real world.” This is an example of the iron triangle. The gains are spread thinly across many people but the losses are large and highly concentrated among a small group. So the losers have more incentive to act than the winners.

11 Trade restriction example 1: tariffs Tariff is a tax on imports. Example: a tariff on cotton shirts. Tariff (T) is $10/shirt Pw is $20/shirt Consumers pay $30 for an imported shirt so that domestic producers charge $30 as well. In general the domestic price Pd = Pw + T

$30 Example 1, tariff on cotton shirts P W = $20 Free trade: buyers demand 80 sellers supply 25 imports = 55 T = $10/shirt price rises to $30 buyers demand 70 sellers supply 40 imports = 30 P Q D S $20 25 Cotton shirts imports

$30 Example 1, tariff on cotton shirts Free trade CS = A + B + C + D + E + F PS = G Total surplus = A + B + C + D + E + F + G Tariff CS = A + B PS = C + G Revenue = E Total surplus = A + B + C + E + G P Q D S $20 25 Cotton shirts 40 A B D E G F C deadweight loss = D + F

$30 Example 1, tariff on cotton shirts D = deadweight loss from the overproduction of shirts F = deadweight loss from the under-consumption of shirts P Q D S $20 25 Cotton shirts 40 A B D E G F C deadweight loss = D + F

15 Trade restriction example 2: quotas Import quotas an quantifiable limits on imports. They work like a tariff, but no tax revenue is raised. Quotas lift prices, reducing Q demanded Quotas reduce buyers welfare but increase producers welfare While quotas raise no revenues that increase profits for foreign producers who sell at a higher price. The revenue lost to the govt could be “captured” by auctioning import licenses. This process happens in carbon taxes-the “pay to pollute” notion I environmental economics.

16 Reviewing the arguments for restricting trade 1. The jobs argument: trade destroys jobs in industries that compete against imports. Analysis: Trade does not directly cause unemployment from the empirical data. Trade implicitly creates more jobs in the US than it destroys. The literature points out that trade has benefit more highly skilled positions and hurt less highly skilled positions—”skills-based” trade. While this skills-based explanation cites “technological change” rather than “trade,” there is a increasing sense that jobs losses are more trade than technology related. So the results are becoming more mixed. 2. National security. An industry vital to national security should be protected from foreign competition, to prevent dependence during wartime “to uncertain sources.” Analysis: Acceptable argument but producers may exaggerate their national security characteristics.

17 Reviewing the arguments for restricting trade 3. Infant-industry argument: a new industry needs support until it can grow and be competitive. Analysis Hard to determine who needs help and/or establish if the costs to consumer is less than benefits to the industry. In addition, it is eventually profitable to grow, the industry can do it on its own. Mild case for helping “key” industry for a new nation. 4. Unfair competition: producer abroad have a unfair advantage due to govt subsidies, etc. Analysis No consumer ever died in a price war, so lower prices are great. We get ultra cheap products. The gains from consumer would outweigh the losses to producers.

18 Reviewing the arguments for restricting trade 5. Protection as bargaining chip: threaten to retaliate to force the other nation to cut their trade restriction on our stuff. Analysis If bluff is taken, either we back down (reducing credibility) or retaliate which (reducing welfare).

19 Trade agreements A country can liberalize trade with: unilateral reduction (with one country) multilateral agreements with more than one nation Examples: GATT, 1962 and on NAFTA, 1993 The World trade office (WTO) enforces trade agreements and helps settle disputes.

20 Summary Exporting country. A country will export if the world price is above the domestic price without trade. Trade raises the producer surplus, reduces consumer surplus, and raises total surplus. Importing country. A country will import a good is the world price is below the domestic price without trade. Trader lower the producer surplus but raises consumer surplus and the total surplus. Tariff. A tariff benefits producers and produces revenue for the govt. but the overall economy loses as the gains are less than the losses to consumers. Common arguments for restricting trade including: protecting jobs, defending national security, helping infant industries, preventing unfair competition, and responding to foreign trade restrictions. Only a few (and under restrictive assumptions) have much merit. Free trade is usually the better policy, particularly if the winners can compensate the losers.