1. © 2007 Thomson South-Western

2. Application: International Trade What determines whether a country imports or exports a good? Who gains and who loses from free trade among countries? What are the arguments that people use to advocate trade restrictions?

3. © 2007 Thomson South-Western THE DETERMINANTS OF TRADE Equilibrium Without Trade –Assume: A country is isolated from rest of the world and produces steel. The market for steel consists of the buyers and sellers in the country. No one in the country is allowed to import or export steel.

4. © 2007 Thomson South-Western Figure 1 The Equilibrium without International Trade Consumer surplus Producer surplus Price of Steel 0 Quantity of Steel Domestic supply Domestic demand Equilibrium price Equilibrium quantity

5. © 2007 Thomson South-Western The Equilibrium Without Trade Results: Domestic price adjusts to balance demand and supply. The sum of consumer and producer surplus measures the total benefits that buyers and sellers receive.

6. © 2007 Thomson South-Western The World Price and Comparative Advantage If the country decides to engage in international trade, will it be an importer or exporter of steel?

7. © 2007 Thomson South-Western The World Price and Comparative Advantage The effects of free trade can be shown by comparing the domestic price of a good without trade and the world price of the good. The world price refers to the price that prevails in the world market for that good.

8. © 2007 Thomson South-Western The World Price and Comparative Advantage If a country has a comparative advantage, then the domestic price will be below the world price, and the country will be an exporter of the good. If the country does not have a comparative advantage, then the domestic price will be higher than the world price, and the country will be an importer of the good.

9. © 2007 Thomson South-Western Figure 2 International Trade in an Exporting Country Price of Steel 0 Quantity of Steel Domestic supply Price after trade World price Domestic demand Exports Price before trade Domestic quantity demanded Domestic quantity supplied

10. © 2007 Thomson South-Western Figure 2 International Trade in an Exporting Country D C B A Price of Steel 0Quantity of Steel Domestic supply Price after trade World price Domestic demand Exports Price before trade

11. © 2007 Thomson South-Western Figure 2 International Trade in an Exporting Country D C B A Price of Steel 0Quantity of Steel Domestic supply Price after trade World price Domestic demand Exports Price before trade Producer surplus before trade Consumer surplus before trade C Consumer surplus after trade B Producer surplus after trade

12. © 2007 Thomson South-Western How Free Trade Affects Welfare in an Exporting Country

13. © 2007 Thomson South-Western THE WINNERS AND LOSERS FROM TRADE The analysis of an exporting country yields two conclusions: – Domestic producers of the good are better off, and domestic consumers of the good are worse off. –Trade raises the economic well-being of the nation as a whole.

14. © 2007 Thomson South-Western The Gains and Losses of an Importing Country International Trade in an Importing Country If the world price of steel is lower than the domestic price, the country will be an importer of steel when trade is permitted. domestic consumers will want to buy steel at the lower world price. domestic producers of steel will have to lower their output because the domestic price moves to the world price.

15. © 2007 Thomson South-Western Figure 3 International Trade in an Importing Country Price of Steel 0 Quantity Price after trade World price of Steel Domestic supply Domestic demand Imports Domestic quantity supplied Domestic quantity demanded Price before trade

16. © 2007 Thomson South-Western Figure 3 International Trade in an Importing Country C B D A Price of Steel 0 Quantity of Steel Domestic supply Domestic demand Price after trade World price Imports Price before trade Consumer surplus before trade Producer surplus before trade

17. © 2007 Thomson South-Western Figure 3 International Trade in an Importing Country C B D A Price of Steel 0 Quantity of Steel Price after trade World price Producer surplus after trade Consumer surplus after trade D B Domestic demand Domestic supply Imports Price before trade

18. © 2007 Thomson South-Western How Free Trade Affects Welfare in an Importing Country

19. © 2007 Thomson South-Western The Gains and Losses of an Importing Country How Free Trade Affects Welfare in an Importing Country The analysis of an importing country yields two conclusions: Domestic producers of the good are worse off, and domestic consumers of the good are better off. Trade raises the economic well-being of the nation as a whole because the gains of consumers exceed the losses of producers.

20. © 2007 Thomson South-Western THE WINNERS AND LOSERS FROM TRADE The gains of the winners exceed the losses of the losers. The net change in total surplus is positive.

21. © 2007 Thomson South-Western The Effects of a Tariff A tariff is a tax on goods produced abroad and sold domestically. Tariffs raise the price of imported goods above the world price by the amount of the tariff.

22. © 2007 Thomson South-Western Figure 4 The Effects of a Tariff Price of Steel 0 Quantity of Steel Domestic supply Domestic demand Price with tariff Tariff Imports without tariff Equilibrium without trade Price without tariff World price Imports with tariff Q S Q S Q D Q D

23. © 2007 Thomson South-Western Figure 4 The Effects of a Tariff Price of Steel 0 Quantity of Steel Domestic supply Domestic demand Imports without tariff Equilibrium without trade Price without tariff World price Q S Q D Producer surplus before tariff Consumer surplus before tariff

24. © 2007 Thomson South-Western Figure 4 The Effects of a Tariff A B Price of Steel 0 Quantity of Steel Domestic supply Domestic demand Price with tariff Tariff Imports without tariff Equilibrium without trade Price without tariff World price Imports with tariff Q S Q S Q D Q D Consumer surplus after tariff

25. © 2007 Thomson South-Western Figure 4 The Effects of a Tariff C G Price of Steel 0 Quantity of Steel Domestic supply Domestic demand Price with tariff Tariff Imports without tariff Equilibrium without trade Price without tariff World price Q S Imports with tariff Q S Q D Q D Producer surplus after tariff

26. © 2007 Thomson South-Western Figure 4 The Effects of a Tariff E Price of Steel 0 Quantity of Steel Domestic supply Domestic demand Price with tariff Tariff Imports without tariff Price without tariff World price Q S Imports with tariff Q S Q D Q D Tariff Revenue

27. © 2007 Thomson South-Western Figure 4 The Effects of a Tariff C G A EDF B Price of Steel 0 Quantity of Steel Domestic supply Domestic demand Price with tariff Tariff Imports without tariff Price without tariff World price Imports with tariff Q S Q S Q D Q D Deadweight Loss Consumer surplus Producer surplus

28. © 2007 Thomson South-Western The Effects of a Tariff

29. © 2007 Thomson South-Western A C T I V E L E A R N I N G 1 Analysis of trade 28 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? Identify CS, PS, and total surplus without trade, and with trade. P Q D S $1500 200 $3000 400 600 Plasma TVs

30. © 2007 Thomson South-Western A C T I V E L E A R N I N G 1 Answers 29 Under free trade, –domestic consumers demand 600 –domestic producers supply 200 –imports = 400 P Q D S $1500 200 $3000 600 Plasma TVs imports

31. © 2007 Thomson South-Western A C T I V E L E A R N I N G 1 Answers 30 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

32. © 2007 Thomson South-Western The Effects of a Tariff A tariff reduces the quantity of imports and moves the domestic market closer to its equilibrium without trade. With a tariff, total surplus in the market decreases by an amount referred to as a deadweight loss.

33. © 2007 Thomson South-Western Tariff: An Example of a Trade Restriction Tariff: a tax on imports Example: Cotton shirts P W = $20 Tariff: T = $10/shirt Consumers must pay $30 for an imported shirt. So, domestic producers can charge $30 per shirt. In general, the price facing domestic buyers & sellers equals (P W + T ).

34. © 2007 Thomson South-Western $30 Analysis of a 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 40 70 80 imports

35. © 2007 Thomson South-Western $30 Analysis of a 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 70 80 deadweight loss = D + F

36. © 2007 Thomson South-Western $30 Analysis of a 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 70 80 deadweight loss = D + F

37. © 2007 Thomson South-Western FYI: Import Quotas: Another Way to Restrict Trade The Effects of an Import Quota An import quota is a limit on the quantity of a good that can be produced abroad and sold domestically. Because the quota raises the domestic price above the world price, domestic buyers of the good are worse off, and domestic sellers of the good are better off. License holders are better off because they make a profit from buying at the world price and selling at the higher domestic price.

38. © 2007 Thomson South-Western The Effects of an Import Quota Price of Steel 0 Quantity of Steel Domestic supply Domestic supply + Import supply Domestic demand Isolandian price with quota Imports without quota Equilibrium with quota Equilibrium without trade Quota Imports with quota Q D World price World price Price without quota = Q S Q D Q S Firms with licenses to import, will supply more. The Supply curve shifts horizontally by the amount of the licensed imports. The quantity of imports is exactly the same as the horizontal shift in the supply curve.

39. © 2007 Thomson South-Western The Effects of an Import Quota A E' C B G D E" F Price of Steel 0 Quantity of Steel Domestic supply Domestic supply + Import supply Domestic demand Isolandian price with quota Imports without quota Equilibrium with quota Equilibrium without trade Quota Imports with quota Q D World price World price Price without quota = Q S Q D Q S Consumer surplus after quota Producer surplus after quota Surplus for firms with licenses

40. © 2007 Thomson South-Western The Effects of an Import Quota

41. © 2007 Thomson South-Western FYI: Import Quotas: Another Way to Restrict Trade With a quota, total surplus in the market decreases by an amount referred to as a deadweight loss. The quota can potentially cause an even larger deadweight loss, if a mechanism such as lobbying is employed to allocate the import licenses.

42. © 2007 Thomson South-Western The Lessons for Trade Policy If government sells import licenses for full value, revenue equals that of an equivalent tariff and the results of tariffs and quotas are identical.

43. © 2007 Thomson South-Western The Lessons for Trade Policy Both tariffs and import quotas... raise domestic prices. reduce the welfare of domestic consumers. increase the welfare of domestic producers. cause deadweight losses.

44. © 2007 Thomson South-Western The Lessons for Trade Policy Other Benefits of International Trade Increased variety of goods Lower costs through economies of scale Increased competition Enhanced flow of ideas

45. © 2007 Thomson South-Western THE ARGUMENTS FOR RESTRICTING TRADE Jobs Argument National-Security Argument Infant-Industry Argument Unfair-Competition Argument Protection-as-a-Bargaining-Chip Argument

46. © 2007 Thomson South-Western Arguments for Restricting Trade 1. The jobs argument Trade destroys jobs in industries that compete with imports. Economists ’ response: Look at the data to see whether rising imports cause rising unemployment …

47. © 2007 Thomson South-Western U.S. Imports & Unemployment, Decade averages, 1956-2005 0% 2% 4% 6% 8% 10% 12% 14% 16% 1956 -65 1966 -75 1976 -85 1986 -95 1996 -2005 Imports (% of GDP) Unemployment (% of labor force)

48. © 2007 Thomson South-Western Arguments for Restricting Trade 1. The jobs argument Trade destroys jobs in the industries that compete against imports. Economists ’ response: Total unemployment does not rise as imports rise, because job losses from imports are offset by job gains in export industries. Even if all goods could be produced more cheaply abroad, the country need only have a comparative advantage to have a viable export industry and to gain from trade.

49. © 2007 Thomson South-Western Arguments for Restricting Trade 2. The national security argument An industry vital to national security should be protected from foreign competition, to prevent dependence on imports that could be disrupted during wartime. Economists ’ response: Fine, as long as we base policy on true security needs. But producers may exaggerate their own importance to national security to obtain protection from foreign competition.

50. © 2007 Thomson South-Western Arguments for Restricting Trade 3. The infant-industry argument A new industry argues for temporary protection until it is mature and can compete with foreign firms. Economists ’ response: Difficult for govt to determine which industries will eventually be able to compete and whether benefits of establishing these industries exceed cost to consumers of restricting imports. Besides, if a firm will be profitable in the long run, it should be willing to incur temporary losses.

51. © 2007 Thomson South-Western Arguments for Restricting Trade 4. The unfair-competition argument Producers argue their competitors in another country have an unfair advantage, e.g. due to govt subsidies. Economists ’ response: Great! Then we can import extra-cheap products subsidized by the other country ’ s taxpayers. The gains to our consumers will exceed the losses to our producers.

52. © 2007 Thomson South-Western Arguments for Restricting Trade 5. The protection-as-bargaining-chip argument Example: The U.S. can threaten to limit imports of French wine unless France lifts their quotas on American beef. Economists ’ response: Suppose France refuses. Then the U.S. must choose between two bad options: A) Restrict imports from France, which reduces welfare in the U.S. B) Don ’ t restrict imports, which reduces U.S. credibility.

53. © 2007 Thomson South-Western Trade Agreements A country can liberalize trade with unilateral reductions in trade restrictions multilateral agreements with other nations Examples of trade agreements: North American Free Trade Agreement (NAFTA), 1993 General Agreement on Tariffs and Trade (GATT), ongoing World Trade Organization (WTO), est. 1995, enforces trade agreements, resolves disputes

54. © 2007 Thomson South-Western CASE STUDY: KORUS FTA Opening up the Korean Beef Market to US Imports (for approx. the same qty and quality meat) Korean Beef Price at Lotte Mart = 31,500/kilo Aust. Beef Price at Lotte Mart = 21,000/kilo

55. © 2007 Thomson South-Western CASE STUDY: KORUS FTA Opening up the Korean Beef Market to USA Imports (for approx. the same qty and quality meat) Safeway (US grocery store chain) retail price in Seattle, WA (doesn ’ t account for shipping and any added expenses) = 7,500/kilo

56. © 2007 Thomson South-Western CASE STUDY: KORUS FTA 305,000 metric tons consumed (2006) Total Spending (only Korean Beef): 19.2 Quad. Total Spending (only Austr. Beef): 12.8 Quad. Total Spending (only US Beef): 4.58 Quad. (Approx. spending assuming above assumptions and US Beef xfer pricing similar to what is found in USA) What is the Korean consumer surplus? What is Korean producer surplus?

57. Summary © 2007 Thomson South-Western The effects of free trade can be determined by comparing the domestic price without trade to the world price. –A low domestic price indicates that the country has a comparative advantage in producing the good and that the country will become an exporter. –A high domestic price indicates that the rest of the world has a comparative advantage in producing the good and that the country will become an importer.

58. Summary © 2007 Thomson South-Western When a country allows trade and becomes an exporter of a good, producers of the good are better off, and consumers of the good are worse off. When a country allows trade and becomes an importer of a good, consumers of the good are better off, and producers are worse off.

59. Summary © 2007 Thomson South-Western A tariff — a tax on imports — moves a market closer to the equilibrium that would exist without trade, and therefore reduces the gains from trade. Import quotas will have effects similar to those of tariffs.

60. Summary © 2007 Thomson South-Western There are various arguments for restricting trade: protecting jobs, defending national security, helping infant industries, preventing unfair competition, and responding to foreign trade restrictions. Economists, however, believe that free trade is usually the better policy.