from Gaining International Trade
Modified version of slides authored by Gwartney, Macpherson and Skipton
The Trade Sector of the United States
The Growth of the U.S. Trade Sector
As is shown here, both exports and imports have grown substantially as a share of the U.S. economy during the last several decades. Their growth has accelerated since 1980. Reductions in transport and communication costs, as well as lower trade barriers have contributed to this growth.
Exports 15
(% of GDP)
Imports 15
(% of GDP)
10
10
5
5
1960
1970
1980
1990
2000
1960
1970
1980
1990
2000
Source: http://www.economagic.com/. The figures are based on data for real imports, exports, and GDP.
Leading Trading Partners of the U.S.
Percent of Total U.S. Trade, 2002
Canada Mexico China Japan Germany United Kingdom South Korea Taiwan France Malaysia All other countries
19.8% 11.9% 9.1% 8.6% 4.9% 3.9% 3.1% 2.5% 2.3% 1.8% 32.2%
Today, Canada, Mexico, China, and Japan are the leading trading partners with the United States. The impact of international trade varies across industries. In some industries, U.S. firms are able to compete quite effectively, while in others they find it difficult to do so.
Gains from Specialization and Trade
Historical Development of Modern Trade Theory
Mercantilism (1500 - 1800)
Regulation to ensure a positive trade balance Critics: possible only for short term. Countries benefit from exporting what they make cheaper than anyone else But: nations without absolute advantage do not gain from trade Nations can gain from specialization, even if they lack an absolute advantage
Absolute advantage (Adam Smith)
Comparative advantage (David Ricardo)
Gains from Trade: An Overview
Most international trade is not between the governments of different nations but rather between the people and firms located in different countries. Like other voluntary exchanges, international trade occurs because both the buyer and the seller expect to gain, and generally do.
If both parties did not expect to gain, they would not agree to the exchange.
With international trade, the residents of different countries can gain by specializing in the production of goods they can produce economically.
They can sell those goods in the world market and use the proceeds to import other goods expensive to produce domestically.
Law of Comparative Advantage
Law of Comparative Advantage:
A group of individuals, regions, or nations can produce a larger joint output if each specializes in the production of goods in which it is a lowopportunity cost producer and trades for goods for which it is a high opportunity cost producer.
Sources of Comparative advantage
The Ricardian model says differences in productivity of labor between countries cause productive differences, leading to gains from trade.
Differences in productivity are usually explained by differences in technology.
The Heckscher-Ohlin model says differences in labor, labor skills, physical capital and land between countries cause productive differences, leading to gains from trade.
Gains from Specialization and Trade
International trade leads to mutual gain because it allows each country to specialize more fully in the production of those things that it does best according to the law of comparative advantage. Trade makes it possible for each country to use more of its resources to produce those goods and services that it can produce at a relatively low cost. With trade, it will be possible for the trading partners to consume a bundle of goods that it would be impossible for them to produce domestically.
Comparative Advantage and Opportunity Cost
The Ricardian model uses the concepts of opportunity cost and comparative advantage.
A country faces opportunity costs when it employs resources to produce goods and services.
A country has a comparative advantage in producing a good if the opportunity cost of producing that good is lower in the country than it is in other countries. A country with a comparative advantage in producing a good uses its resources most efficiently when it produces that good compared to producing other goods.
The Ricardian Model: Graphical Illustration
The production possibility frontier (PPF) of an economy shows the maximum amount of a goods that can be produced for a fixed amount of resources. Slope: = marginal rate of transformation, shows the opportunity cost of making more of one good Example: Suppose using all available resources the US can produce either 60 bushels of wheat or 120 autos or a certain combination of the two products Similarly Canada can produce either 160 bushels of wheat or 80 autos or a certain combination of both
Marginal Rate of Transformation
Production possibilities schedules: constant opportunity costs
Supply schedules: constant opportunity costs
Trading under constant opportunity costs
Production gains from specialization: constant
opportunity costs
Before Specialization
Autos Wheat US Canada World 40 40 80 40 80 120
After Specialization
Autos Wheat 120 0 120 0 160 160
Net Gain (Loss)
Autos Wheat 80 -40 40 -40 80 40
Gains from Specialization and Trade
As long as relative production costs of two goods differ between two countriesfor example, U.S. and Japan gains from trade will be possible.
Output per worker day Food Clothing (1) (2) 2 3 1 9 Potential change in output* Food Clothing (3) (4) +6 -3 +3 -3 +9 +6
Country United States Japan Change in total output
* Change in output if US shifts 3 workers from clothing to food industry and if Japan shifts one from food to clothing.
Columns (1) and (2) indicate the daily per worker output of the food and clothing industry in the U.S. and Japan. If the U.S. moves 3 workers from clothing to food, it produces 6 more units of food and only 3 fewer of clothing. If Japan moves 1 worker from food to clothing, it produces 9 more units of clothing and only 3 fewer of food. With such a reallocation of labor, the U.S. and Japan are able to increase their aggregate output of both food and clothing.
PPC before Specialization and Trade
Here we illustrate the daily production of the labor force of both the US (200 million) and Japan (50 million) given the production costs of food and clothing from the previous slide. In the absence of trade, consumption possibilities will be restricted to points like US1 in the U.S. and J1 in Japan. Each of these points lay along the production possibilities curve (PPC) of the respective nation.
United States
Clothing 450 375 300 225 150 75
(million units)
Clothing
(million units)
Japan
450 400 350 Production possibilities, U.S. 300 250 M 200 150 US1 100 50 N Food 100 200 300 400 (million units)
R Production possibilities, Japan J1
S
75 150 225 300 450
(million units)
Food
Trade Expands Consumption Possibilities
Specialization and trade expand consumption possibilities. If the U.S. trades food for clothing (1-for-1), it can specialize in the production of food and consume along the ON line (rather than its original production-possibilities constraint, MN). Similarly, if Japan trades clothing for food (1-for-1), it can specialize in the production of clothing and consume any combination along the RT line (rather than its original, RS).
United States Consumption possibilities of U.S. with trade
Clothing 450 375 300 225 150 75 200 300 Food 400 (million units)
(million units)
Clothing
(million units)
Japan Consumption possibilities of Japan with trade
450 400 O 350 300 250 M 200 150 US1 100 50 100
R
J1
N
S
75 150 225 300
T
450
(million units)
Food
Trade Expands Consumption Possibilities
For example, with specialization and trade, the U.S. could increase its consumption from US1 to US2, gaining 50 million units of clothing and 100 million units of food. Simultaneously, Japan could increase consumption from J1 to J2, a gain of 125 million units of food and 25 million units of clothing.
United States
Clothing 450 375 300 250 225
(million units)
Clothing
(million units)
Japan
450 400 O 350 300 250 M 200 150 US1 100 50 100
R
US2
J1
J2
150 75
200
300
Food 400 (million units)
N
S
75 150 225 200 300
T
450
(million units)
Food
Trade Expands Consumption Possibilities
How exactly do the U.S. and Japan consume at US2 and J2? The U.S. produces 400 million units of food, consumes 200 million, and exports 200 million to Japan. Japan produces 450 million units of clothing, consumes 250 million, and exports 200 million to the U.S.. They consume more together than they could individually.
United States
Clothing 450 375 300 250 225
Japan exports (million units)
Clothing 450 400 O 350 300 250 M 200 150 100 50
(million units)
Japan
R
J2
US2
150 75
US exports
US imports
N
100
200
300
400 (million units)
Food
Japan imports
T
300 450
S 150
225 200
(million units)
Food
International Trade is a Key to Prosperity
In addition to gains from specialization in areas of comparative advantage, international trade also leads to gains from:
Economies of Scale: International trade allows both domestic producers and consumers to gain from reductions in per-unit costs that often accompany large-scale production, marketing, and distribution. More Competitive Markets: International trade promotes competition in domestic markets and allows consumers to purchase a wider variety of goods at economical prices.
Supply, Demand, and International Trade
U.S. Has a Comparative Advantage
The price of soybeans and other internationally traded commodities is determined by the forces of supply and demand in the world market. If U.S. soybean producers were prohibited from selling to foreigners, the domestic price would be Pn. Free trade permits U.S. soybean producers to sell Qp units at the higher world price of Pw.
World Market Price
U.S. Market
Sd
a b
Price
Sw
Pw Pn
Pw
c
d
w
D
Qc Qn Qp
D
Soybeans
(bushels)
Qw
Soybeans
(bushels)
U.S. Has a Comparative Advantage
At the world price of Pw, the quantity (Qp Qc) is exported. Compared to the no-trade situation, the producers gain from the higher price (Pw b c Pn) exceeds the cost imposed on domestic consumers (Pw a c Pn) by the triangle (area) a b c.
U.S. Market Price
World Market
Sd
a b
Price
Sw
Pw Pn
U.S. exports
Pw
c
d
w
D
Qc Qn Qp
D
Soybeans
(bushels)
Qw
Soybeans
(bushels)
Foreigners Have a Comparative Advantage
Consider the international market for manufactured shoes. In the absence of trade, the domestic price would be Pn. Since many foreign producers have a comparative advantage in the production of shoes, international trade leads to lower prices Pw.
World Market Price
U.S. Market
Sd
Price
Sw
Pn a Pw
d
D
Qn
w
Shoes
Qw
D Shoes
Foreigners Have a Comparative Advantage
U.S. Market Price
At the price Pw, U.S. consumers demand Qc units of which (Qc Qp) are imported. Compared to no trade, consumers gain Pn a b Pw, while domestic producers lose Pn a c Pw. A net gain of a b c results.
World Market Price
Sd
Sw
Pn Pw
U.S. imports
a c b
d
Pw
D
Qp Qn Qc
w
Shoes
Qw
D Shoes
Summary:
Supply, Demand, & Gains from Trade
International trade and specialization result in lower prices (and more domestic consumption) for imported products and higher prices (and less domestic consumption) for exported products. Trade makes it possible for domestic producers to obtain higher prices for the items they export and for domestic consumers to buy imported items at lower prices. As a result, the residents of each nation are able to focus more of their resources on the things they do best (produce at a low cost), while trading for those they do least well.
Questions for Thought:
4. Are the following statements true or false?
a. If a nation is going to produce its maximum potential output and achieve full employment, it must impose tariffs and quotas in order to protect domestic industries and jobs. b. When a country trades for those things for which it is a high cost producer, it will be able to use more of its resources to produce items it can produce at a low cost.
The Economics of Trade Restrictions
U.S. Tariff Rates: 1860 to the Present
U.S. Average Tariff Rate
(Duties collected as a share of dutiable imports)
60% 50% 40% 30% 20% 10% 1860
4.0% 1880 1900 1920 1940 1960 1980 2000
The average tariff rate (taxes levied upon imports) for the United States (since 1860) is illustrated above.
Trade Restrictions: Impact of a Tariff.
Consider a tariff on auto imports. Without a tariff, the world price of autos is Pw. At Pw consumers Price in the U.S. purchase Q1 units SDomestic Qd1 from U.S. producers and Q1 Qd1 from foreign producers. A tariff t makes it more costly for Americans to purchase autos from Imports after tariff abroad. prices U.S. rise to Pw+ t and purchases fall from Q1 to Q2. Pw+ t Tariff = t U.S. purchases from domestic S U T V Pw producers rise from Qd1 to Qd2 Initial Domestic imports imports fall to Q2 Qd2. Producers gain area S the tariff D generates T tax revenues areas Quantity U & V are deadweight losses from (automobiles) Qd1 Qd2 Q2 Q1 reduction in lose S + U efficiency. Consumers allocative + T + V in the form of higher prices and a reduction of consumer surplus.
Trade Restrictions: Impact of a Quota
Consider a quota on peanuts. Without trade restraints, Pw (the world price of peanuts) would be the domestic price. At Pw U.S. consumers would purchase Q1 Qd1 from U.S. producers and Q1 Qd1 imported from abroad. A quota of Q2 Qd2 imports pushes the U.S. price up to P2. While total U.S. purchases fall (from Q1 to Q2), those from U.S. producers rise (from Qd1 to Qd2) and imports fall to Q2 Qd2. U.S. producers gain area S. Area T goes to foreign producers with permits to import into the U.S. U & V are deadweight losses. Consumers lose S + U + T + V in the form of higher prices and a reduction of consumer surplus.
Price
SDomestic
Import quota:
P2 Pw
S U T V
Q2 Qd2
Initial Domestic imports
D
Qd1 Qd2 Q2 Q1
Quantity
(peanuts)
Note: The government derives no additional revenue from quotas.
Why do Nations Adopt Trade Restrictions?
Arguments Used to Justify Trade Restrictions
Proponents of trade restrictions often use the following arguments in an effort to justify their position:
National defense argument Dumping: the sale of goods abroad at a price below the cost of production (and below the domestic market price of the exporting nation). Dumping is illegal under U.S. law. Infant Industry argument
A Few Additional Issues Related to Dumping
When considering the merits of anti-dumping restrictions, remember that:
Firms with large inventories (either domestic or abroad) may find it in their interest to offer goods at prices below their cost of production. Domestic firms may engage in this practice. Lower prices benefit domestic consumers.
Trade Restrictions are a Special Interest Issue
Protectionism is a politician's delight because it delivers visible benefits to the protected parties while imposing the costs as a hidden tax on the public Murray L. Weidenbaum The special interest effect provides the primary explanation for trade restrictions. Trade restrictions almost always provide highly visible, concentrated benefits for a small group of people, while imposing widely dispersed costs that are often difficult to identify on the general citizenry. Politicians have a strong incentive to favor special interest issues, even if they conflict with economic efficiency.
Why Some People Object to Free Trade
Given the clear benefits that nations can derive by specializing and trading
Why would anyone ever object to free international trade?
Despite benefit to nation as a whole, some groups within the country, in short-run, are likely to lose from free trade
Even while others gain a great deal more
Instead of finding ways to compensate the losers
Often allow them to block free-trade policies
The Impact of Trade
China Price (Dollars) Price (Dollars) $500 Supply Exports $350 $250 A E Demand 200 300 150 Thousand s of Suits per Month 250 310 160 Thousands of Suits per Month B $350 C Imports Demand D F United States Supply
The Impact of Trade in the Exporting/Importing Country
When opening of trade results in increased exports of a good
Producers of the good are made better off Consumers of the good in exporting country will be made worse off
When opening of trade results in increased imports of a product
Domestic producers of the product are made worse off Consumers of the good in importing country are better off
Tariff and Non Tariff Barriers
Tariff
Specific Tariff: Is a fix fee per unit of import Ad Valorem Tariff: It is fee as % of value of import
Quota Custom Administration
Bill of Origin Documentation Testing Quality requirement Administrative fees boarder tax
Standards
Other Charges
How Free Trade Is Restricted
When government decides to accommodate opponents of free trade
It is apt to use tariffs or quotes to restrict trade Tax on imported goods Can be a fixed dollar amount per physical unit or a percentage of goods value In either case, effect in tariff-imposing country is similar Both countries, as a whole, are worse off Tariffs reduce volume of trade and raise domestic prices of imported goods In the country that imposes the tariff, producers gain and consumers lose World as a whole loses, because tariffs decrease volume of trade and therefore decrease gains from trade
Tariffs
How Free Trade Is Restricted
Quotas
Government decree limiting imports of a good to a specified maximum physical quantity Because goal is to restrict imports, a quota is set below the level of imports that would occur under free trade General effects are same as a tariff Reduce quantity of imports and raise domestic prices They reduce benefits of trade to the nation as a whole Increased government revenue
While both tariffs and quotas help domestic producers
However, a tariff has one saving grace
Popular Trade Fallacies
Trade Fallacies
Trade fallacies abound because people often do not consider the secondary effects. Key elements of international trade are often linked you cannot change one element without changing the other.
This is the case with imports and exports; policies that restrain imports also restrain exports.
Trade Fallacies
Trade fallacy 1:
Trade restrictions that limit imports save jobs for Americans. This view is false because if foreigners sell less to us they will have fewer dollars with which to buy things from us. Thus, restraints on imports will also restrain exports. Trade restrictions do not save jobs; they merely reshuffle them. Jobs saved in protected industries will be offset by jobs lost in export industries. As the result of trade restrictions, fewer Americans are employed in areas where we have a comparative advantage.
Trade Fallacies
Trade fallacy 2:
"Free trade with low-wage countries, such as Mexico and China, will reduce the wages of Americans." Both high- and low-wage countries will gain when they are able to focus more of their resources on those productive activities that they do well. The key to this issue is how will U.S. resources be used. If a low-wage country can supply a good cheaper than we can produce it, the U.S. can gain by purchasing the good from the low-wage country and using its resources to produce other goods for which it has a comparative advantage.
Trade Fallacies
Free trade is beneficial only if a country is more productive than foreign countries.
But even an unproductive country benefits from free trade by avoiding the high costs for goods that it would otherwise have to produce domestically. High costs derive from inefficient use of resources. The benefits of free trade do not depend on absolute advantage, rather they depend on comparative advantage: specializing in industries that use resources most efficiently.
Trade Fallacies
Free trade with countries that pay low wages hurts high wage countries.
While trade may reduce wages for some workers, thereby affecting the distribution of income within a country, trade benefits consumers and other workers. Consumers benefit because they can purchase goods more cheaply (more wine in exchange for cheese). Producers/workers benefit by earning a higher income (by using resources more efficiently and through higher prices/...