1. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. International Trade Policy Chapter 21

2. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Laugher Curve A Harvard economist died and went to heaven — No, that’s not the joke. There were thousands of people ahead of him in line to see St. Peter.

3. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Laugher Curve To his surprise, St. Peter left his desk at the gate and came down the long line to where the economist was, and greeted him warmly. St. Peter took the economist up to the front of the line, and into a comfortable chair by his desk.

4. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Laugher Curve The economist said, “I like all this attention, but what makes ME so special?” St. Peter replied, “Well, I’ve added up all the hours for which you billed your consultation clients, and by my calculations you’re 193 years old.”

5. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Patterns of Trade n Most economists oppose trade restrictions.

6. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Increasing but Fluctuating World Trade n Sometimes international trade has grown rapidly – other times it has grown slowly. l It was about $500 billion in today’s dollars in 1928 – 60% of U.S. GDP. l In 1935 the ratio was 30% – in 1950 it was 20% l It is about $8 trillion today – 65% of U.S. GDP.

7. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Increasing but Fluctuating World Trade n Fluctuations in world trade result in part from fluctuations in world output. n Fluctuations are also explained in part by trade restrictions that nations have imposed from time to time.

8. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Differences in the Importance of Trade n The importance of international trade to countries’ economies differs widely. n For most nations, imports and exports roughly correspond.

9. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Differences in the Importance of Trade Total OutputExport RatioImport Ratio United States$10,08210%14% Canada87543%38% Netherlands41367%62% Germany2,17435%33% United Kingdom1,47034%40% Italy1,40221% France1,51028%26% Japan3,45010%9%

10. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. What and With Whom the U.S. Trades n The majority of U.S. exports and imports involve manufactured goods. n The primary trading partners of the U.S. are Canada, Mexico, the European Union, and Pacific Rim countries. n U.S. imports have exceeded exports in recent years.

11. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. What and With Whom the U.S. Trades n The U.S. balance of trade shows a trade deficit rather than a trade surplus. n Balance of trade – the difference between the value of exports and the value of imports.

12. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. What and With Whom the U.S. Trades n Trade deficit – an excess of imports over exports. n Trade surplus – an excess of exports over imports.

13. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. U.S. Exports by Region, 2001 European Union 22% Pacific Rim 24% OPEC 3% Central and South America 8% Mexico 14% Other 4% European Union 22% Other Europe 3%

14. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. U.S. Imports by Region, 2001 European Union 19% Pacific Rim 32% OPEC 5% Central and South America 6% Mexico 12% Other 2% European Union 19% Other Europe 5%

15. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Debtor and Creditor Nations n Following World War II, the U.S. ran trade surpluses. n In recent years, the U.S. has run a significant trade deficit.

16. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Principle of Comparative Advantage n The principle of comparative advantage states that as long as the relative opportunity costs of producing goods differ among nations, there are potential gains from trade.

17. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Gains From Trade n Saudi Arabia has a comparative advantage in producing oil and the U.S. has a comparative advantage in producing food. l The cost of producing one ton of food in Saudi Arabia is 10 barrels of oil. l The cost of producing one ton of food in the U.S. is 1/10 of a barrel of oil.

18. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Gains From Trade n Saudi Arabia is producing 400 barrels of oil and 60 tons of food. n The U.S. is producing 60 barrels of oil and 400 tons of food.

19. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Gains From Trade n The following tables demonstrate how output increases when two nations specialize in the activity for which each has a comparative advantage.

20. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Gains From Trade

21. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Gains From Trade

22. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Gains From Trade

23. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Gains From Trade

24. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Dividing up the Gains From Trade n The more competition, the less the trader gets. n Smaller nations get a larger proportion of the gain than larger nations. n Nations producing goods with economies of scale get a larger gain from trade.

25. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Varieties of Trade Restrictions n Trade restrictions include: l Tariffs and quotas. l Voluntary restraint agreements. l Embargoes. l Regulatory trade restrictions. l Nationalistic appeals.

26. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Tariffs n Tariffs (custom duties) are taxes governments place on internationally traded goods. n Tariffs make imported goods relatively more expensive – encouraging the consumption of domestically produced goods.

27. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Tariffs n The Smoot-Hawley Act of 1930 was a disaster that raised tariffs on imports to 60 percent. n Other countries responded with similar trade restrictions.

28. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Tariffs n The dismal failure of Smoot-Hawley was the main reason the GATT was established in 1947. n General Agreement on Tariffs and Trade (GATT) – a regular international conference to reduce trade barriers.

29. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Tariffs n GATT was replaced by the World Trade Organization in 1995. n World Trade Organization (WTO) an organization whose functions are generally the same as GATT – promote free and fair trade among nations.

30. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Quotas n Quotas are quantity limits placed on imports. n Both tariffs and quotas increase price and reduce quantity.

31. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Quotas n Under a tariff, the government collects the tariff revenue. n Under a quota, the domestic price is the same as a tariff and the importer gets the revenue.

32. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. P1P1 P0P0 Q1Q1 Q0Q0 S0S0 S1S1 D T = Tariff Quantity A Tariff and a Quota A quota limiting foreign quantity supplied to Q 1 is the equivalent of a tariff of T

33. Tariff revenue Foreign Supply of a Good When the Domestic Country is Small With a Tariff 2.00 2.50 Initial imports Domestic supply Domestic demand $3.00 100 125175 200 World price with tariff Price Quantity World price = World supply t McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

34. Foreign Supply of a Good When the Domestic Country is Small With a Quota Price Quantity 2.00 2.50 Quota Domestic supply Domestic demand $3.00 100 125175 200 World supply with quota World price = World supply McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

35. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Voluntary Trade Agreements n Voluntary trade agreements are agreements to limit exports. n Voluntary trade agreements are often not all that voluntary.

36. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Voluntary Trade Agreements n The effect of such voluntary restraint agreements is identical to the effect of quotas. l The quantity of imports is directly limited. l The price of the good increases helping domestic producers.

37. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Embargoes n An embargo is an all-out restriction on import or export of a good. n Embargoes are usually established for international political reasons rather than for economic reasons.

38. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Regulatory Trade Restrictions n Regulatory trade restrictions are government-imposed procedural rules that limit imports. n Some regulatory restrictions are legitimate. n Others are designed simply to make importing more difficult.

39. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Nationalistic Appeals n Nationalistic appeals are also ways to limit trade. n The “Buy American” campaign is an example.

40. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Reasons for Trade Restrictions n Unequal internal distribution of the gains from trade. n Haggling by companies over the gains from trade. n Haggling by countries over trade restrictions.

41. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Reasons for Trade Restrictions n Specializing production: learning by doing and economies of scale. n Macroeconomic aspects of trade. n National security. n International politics. n Increased revenue brought in by tariffs.

42. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Unequal Internal Distribution of the Gains From Trade n People don’t like losing their jobs because foreign goods are cheaper so they lobby to prevent foreign competition. n Setting up tariffs or quotas in order to save domestic jobs costs the economy money.

43. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Unequal Internal Distribution of the Gains From Trade n Benefits of trade are generally widely scattered among the entire population. n In contrast, costs of free trade often fall on specific small groups.

44. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Unequal Internal Distribution of the Gains From Trade n Trade adjustment assistance programs have been instituted because eliminating trade restrictions often make some people worse off. n Trade adjustment assistance programs – programs designed to compensate losers for reductions in trade restrictions.

45. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Haggling by Companies Over the Gains From Trade n Trade can be restricted when companies haggle over the gains of trade. n Strategic bargaining – demanding a larger share of the gains from trade than you can reasonably expect.

46. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Haggling by Companies Over the Gains From Trade n If strategic bargaining is successful, you get the most from the bargain, but you risks having the deal fall through.

47. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Haggling by Countries Over Trade Restrictions n Trade restrictions and the threat of trade restrictions play an important role in strategic bargaining. n The smaller a country’s gains from trade, the stronger its bargaining position.

48. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Specialized Production n It is often not at all clear why particular nations have a productive advantage in certain goods. n These nations may learning by doing and economies of scale may exist.

49. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Learning by Doing n Learning by doing means becoming better at a task the more often you perform it. n When there is learning by doing, it is much harder to assign comparative advantage to a country.

50. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Economies of Scale n If significant economies of scale exist, it makes sense for one country to specialize in one good while another specializes in another good. n Economies of scale – cost per unit of output falls as output increases.

51. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Economies of Scale n A number of countries follow trade strategies to take advantage of economies of scale. n A variety of trade restrictions are based on economies of scale and learning by doing.

52. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Economies of Scale n Countries use the infant industry argument to justify many trade restrictions. n Infant industry argument – with initial protection, an industry will be able to become competitive.

53. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Macroeconomic Aspects of Trade n When a nation is in a recession, there is a strong macroeconomic reason to limit imports and encourage exports. l Pressure to impose trade restrictions increases substantially.

54. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. National Security n Limiting trade on grounds of national security takes two forms: l Export restrictions on strategic materials and defense-related goods. l Import restrictions on defense-related goods.

55. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. International Politics n U.S. trade restrictions on Cuba and on Iraq are politically motivated. n The reasoning – if trade helps you, refusing to trade with you hurts you.

56. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Increased Revenue Brought in by Tariffs n In the 1800s, tariffs were the principal source of revenue for the U.S. government. n They remain a primary source of revenue for developing nations.

57. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Why Economists Generally Oppose Trade Restrictions n Economists generally oppose trade restrictions because: l Free trade increases total output globally. l International trade provides competition for domestic companies. l Restrictions based on national security are often abused or evaded. l Trade restrictions are addictive.

58. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Free Trade Increases Total Output n From a global perspective, free trade increases total output. n Trade restrictions can only benefit a nation if other countries don’t retaliate. n Retaliation is the rule, not the exception.

59. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. International Trade Provides Competition n International competition is desirable because it forces domestic firms to stay on their toes.

60. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. International Trade Provides Competition n In theory, the infant industry argument makes sense. n Very few of these industries have ever grown up.

61. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Restrictions based on National Security Are Abused or Evaded n The national security argument is often carried to ridiculous extremes. n It is fairly easy to get around national security concern by transshipments of arms.

62. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Restrictions based on National Security Are Abused or Evaded n Economists argue that by fostering international cooperation, international trade makes war less likely.

63. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Trade Restrictions are Addictive n Trade restrictions are addictive – the more you have, the more you want. n Some trade restrictions may benefit a nation, but almost no nation can limit its restrictions to the beneficial ones.

64. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Institutions Supporting Free Trade n Free trade associations – groups of nations that allow free trade among its members. n As a group, they put up common barriers against all other nations’ goods.

65. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Free Trade Associations n The most famous free trade association is the European Union (EU). n In 1993, the U.S., Canada, and Mexico formed the North American Free Trade Association (NAFTA).

66. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Free Trade Associations n Countries use most-favored-nation status to strengthen trading relationships among themselves. n A most-favored-nation is one that will be charged as low a tariff on its exports as any other country.

67. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. International Trade Policy End of Chapter 21