Trade
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chapter
Gerald COREECONOMICS
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International Stone
Chapter Outline
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The Gains From Trade The Terms of Trade Arguments Against Free Trade The Dynamics of Trade: Cashmere
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Learning Objectives
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At the end of this chapter, the student will be able to:
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Describe the benefits of free trade. Distinguish between absolute and comparative advantage. Illustrate the economic impacts of trade. Define the terms of trade. List the ways in which trade is restricted. Discuss the various arguments against free trade. Debate the issues surrounding increasing global economic integration.
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Voluntary Trade
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Many people assume that trade between nations is a zero sum game: a game in which, for one party to gain, the other party must lose. But voluntary exchange is in fact a positive sum game, meaning that both parties to a transaction can gain. When an exchange takes place between individuals or firms in different countries, we refer to this as international trade.
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Absolute and Comparative Advantage
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An absolute advantage exists when one country can produce more of a good than another country. One country enjoys a comparative advantage in producing a particular good if it can do so at the lowest opportunity cost. If each country specializes according to its comparative advantage, both nations can be made better off through trade.
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Practical Constraints on Trade
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Some practical constraints on trade: w First, every transaction involves costs, including transportation, communications, and the general costs of doing business. Over the last several decades, however, transportation and communication costs have declined. w Second, the production possibilities curves for nations are not linear; they are governed by increasing costs and diminishing returns. Countries find it difficult to specialize only in one product. Doing so is risky since the market for the product can always decline. This is a perennial problem for developing countries that often build their exports and trade around one agricultural commodity.
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Effects of Voluntary Trade
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Although it is true that trading partners will benefit from trade, some individuals and groups within each country may lose. Individual workers in those industries at a comparative disadvantage are likely to lose their jobs, and thus may require retraining, relocation, or other help if they are to move smoothly into new occupations.
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Checkpoint
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The Gains From Trade
An absolute advantage exists when one country can produce more of a good than another country. A comparative advantage exists when one country can produce a good at a lower opportunity cost than another country. Both countries gain from trade when each specializes in producing that commodity in which they have a comparative advantage. Transaction costs, diminishing returns, and the risk associated with specialization all place some practical limits on trade.
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The Terms of Trade
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When countries trade many commodities, the terms of trade are defined as the average price of exports divided by the average price of imports. As a country devotes more resources to producing one particular item, it will encounter increasing opportunity costs. As each product settles into an equilibrium price, the terms of trade are established.
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Winners and Losers in Free Trade
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The story of free trade is that some sectors of the economy win and some others lose. American consumers have been happy to purchase Japanese cameras such as Minolta and Nikon, given their high quality and low prices. American camera makers such as Kodak and Polaroid have not been so pleased, nor have their employees. These firms, watching their prices, sales, and employment decline, have had to adapt to the competition from abroad.
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Winners and Losers in Free Trade
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Similarly, the ranks of American textile workers have been decimated over the past two decades as domestic clothing producers have increasingly shifted production overseas to countries where wages are lower. To be sure, American consumers have enjoyed a substantial drop in the price of clothing, because labor forms a significant part of the cost of clothing production. Still, being able to purchase inexpensive T-shirts made in China is small consolation for the unemployed textile worker in North Carolina.
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Trade Restrictions
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Trade restrictions can range from subsidies provided for domestic firms to protect them against lower-priced imports to embargos where the government bans any trade with a country. Between these two extremes are more intermediate policies, such as exchange controls that limit the amount of foreign currency available to importers or citizens who travel abroad. Regulation and licensing can be used to promote or ensure the purchase of domestic products.
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Trade Restrictions
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The main reason for trade restrictions is simple:
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An industry that competes against imports lobbies for protection, while the huge benefits of potentially lower prices are diffused among millions of customers whose benefits are each so small that fighting against a trade barrier isnt worth their time.
The most common forms of trade restrictions are tariffs and quotas.
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A tariff is a tax collected on imports; a quota restricts the volume of imports.
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Tariffs
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Tariffs are often ad valorem taxes. This means the product is taxed by a certain percentage of its price as it crosses the border. Other tariffs are unit taxes: a fixed tax per unit of the product is assessed at the border. Tariffs are designed to generate revenues and to drive a wedge between the domestic price of a product and its price on the world market. In the nineteenth century, import tariffs were the dominant source of revenue for the US federal government.
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Effects of a Tariff
25 S chapter Under the effects of a tariff, domestic consumers pay more than they would otherwise. Some of this added expense is collected by domestic producers in the form of higher prices. The rest is collected as government revenue (the amount of the shaded area). D
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Quotas
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Under a quota system, the government limits imports to a specified quantity. No revenue is collected for the government, but consumers pay higher prices due to the restricted quantity. This translates into more profit for the manufacturer.
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The United States imposes quotas on Japanese automobiles. The primary effect of these quotas has been to dramatically raise the minimum standard equipment and price for some Japanese cars and to increase the number of Japanese cars made in American factories. If a firm is limited in the number of vehicles it can sell, why not sell higher-priced ones where the profit margins are higher?
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Effects of a Quota
25 S A quota is a restriction on the quantity of imports. The domestic price will rise to the market-clearing level, but no revenue is collected for the government. chapter
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CheckpointThe Terms of Trade
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The terms of trade are determined by the ratio of the price of exported goods to the price of imported goods. The terms of trade are set by the markets in each country and by exports and imports that eventually equalize the prices. Trade leads to winners and losers in each country and in each market. Trade restrictions vary from subsidies to domestic firms to government ban on the import of foreign products.
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CheckpointThe Terms of Trade
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Tariffs are taxes on imports that protect domestic producers and generate revenue. Quotas represent restrictions on the volume of particular imports that can come into a country. Quotas do not generate revenue for governments and are infrequently used.
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Arguments Against Free Trade
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The arguments against free trade fall into two camps: The first are traditional economic arguments including protection for infant industries, protection against dumping, low foreign wages, and support for industries judged vital for national defense. Second are globalization concerns that embody political-economy characteristics. These include domestic employment issues, environmental concerns, and the impact of globalization on working conditions in developing nations.
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Traditional Economic Arguments
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The Infant Industry Argument
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An infant industry, it is argued, is one that is too underdeveloped to achieve comparative advantage or perhaps even to survive in the global environment. Unless the industrys government provides it with some protection through tariffs, quotas, or subsidies, it might not survive in the face of foreign competition.
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Traditional Economic Arguments
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Drawbacks of the Infant Industry Argument:
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First, protecting an industry must be done in a way that makes the industry internationally competitive. Second, infant industry protection often tends to focus on capital manufacturing. Countries with abundant labor supplies, however, would do better to develop their labor intensive industries first, letting more capital intensive industries over develop time. Third, many industries seem to be able to develop without protections, so countries may be wasting their resources and reducing their incomes by imposing protection measures.
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Traditional Economic Arguments
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Antidumping Argument:
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Dumping means that goods are sold at lower prices below cost abroad than in their home market. This often is a result of government subsidies. Firms can use dumping as a form of predatory pricing, charging higher prices in their domestic markets to support unrealistically low prices in foreign markets. If the federal government determines that a foreign firm is dumping products onto the American market, it can impose antidumping tariffs on the offending products. The government, however, must distinguish between dumping, legitimate price discrimination, and legitimate instances of lower cost production arising from comparative advantage.
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Traditional Economic Arguments
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Low Foreign Wages:
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Some advocates of trade barriers maintain that domestic firms and their workers need to be protected from displacement by cheap foreign labor. On balance, however, the benefits of lower priced goods considerably exceed the costs of lost employment. The federal government has resisted imposing protection measures for the sake of protecting jobs, instead funding programs that help displaced workers transition to new lines of work.
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Traditional Economic Arguments
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National Defense:
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In times of national crisis or war, the United States must be able to rely on key domestic industries, such as oil, steel, and the defense industry. Some have argued that these industries may require some protection even during peacetime to ensure that they are already well established when crisis strikes and importing key products may be impossible.
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Globalization Concerns
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Trade and Domestic Employment
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Some firms, unable to compete with imports, will be forced to lay off workers. Even so, increased trade usually allows firms that are exporters to expand their operations and hire new workers. Clearly, those industries that are adding workers and those that are losing jobs are different industries. For workers who lose their jobs, switching industries can be difficult and time consuming. American trade policy recognizes this problem, and the Trade Adjustment Assistance program (TAA) provides workers with job search assistance, job training, and some relocation allowances.
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Globalization Concerns
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Trade and the Environment:
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We have seen that trade raises incomes in developing countries. And environmental protection is an income elastic good: as incomes rise, the demand for environmental protections rises faster. Studies suggest that once a countrys per capita income exceed roughly $5,000, its environmental protection efforts begin to improve. In poor developing nations, environmental protection will not at first be an issue. Critics of globalization are concerned that because environmental and labor standards in many developing nations are well below those elsewhere, there will be pressure to adopt these lower standards in rich nations.
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Globalization Concerns
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Trade and the Environment
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But as professors Bhagwati and Hudec argue, there has been no systematic race to the bottom. Many corporations often have the highest environmental and labor standards in the developing world. Also, it is worth noting that over time, as incomes rise, environmental protection takes on added importance even in poorer nations. On balance, trade probably benefits the environment over the longer term as incomes grow in developing nations, allowing environmental protections to take on greater importance.
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Globalization Concerns
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Working Conditions in Developing Nations:
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Some anti-globalization activists argue that trade with developing countries simply exploits workers where wages are low. But it is not clear that workers would be helped if the United States were to cut off its trade with low-wage countries. Restricting trade with countries that do not raise their wages to levels we think acceptable or bring working conditions up to our standards would probably do more harm than good. Low wages reflect low productivity and low living standards characteristic of developing nations. Blocking trade with these nations may deprive them of their key chance to grow and to improve in those areas where we would like to see change.
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CheckpointArguments Against Free Trade
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The infant industries argument claims that some industries are so underdeveloped that they need protection to survive in a global competitive environment. Dumping involves selling products at different prices in domestic and foreign markets, often with the help of subsidies from the government. This is a form of predatory pricing to gain market share in the foreign market. Some suggest that domestic workers need to be protected from the low wages in foreign countries. This puts the smaller losses to small groups ahead of the greater general gains from trade. Also, for many countries, low labor cost is their primary comparative advantage.
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CheckpointArguments Against Free Trade
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Some argue that select industries need protection for national defense reasons. Globalization has meant that some U.S. workers have lost jobs to foreign competition and some advocates would restrict trade on these grounds alone. But, on net, trade has led to higher overall employment.
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CheckpointArguments Against Free Trade
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Concern about the environment is often a factor in trade negotiations. But because it leads to higher incomes, trade ultimately raises environmental awareness in developing nations. Some anti-globalization activists consider shifting production to countries with low wages as exploitation and demand that wages be increased in other countries. Globalization has typically resulted in higher wages in developing nations, but not up to the standards of developed nations.
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The Dynamics of Trade: Cashmere
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The modern cashmere industry began in the 19th century when British colonialists in India discovered the fancy shawls of the Indian rulers. The name cashmere comes from Kashmir, the home of the goats used to provide the special soft fleece. Since that time, the goat herders moved to Inner Mongolia, part of China. The modern cashmere industry began when British entrepreneurs acquired the cashmere fleece and sent it to Scotland for weaving. Scottish companies became the main suppliers of finished cashmere. There were some Italian producers as well, though the Scottish firms predominated.
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The Dynamics of Trade: Cashmere
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This is changing. Competition had been limited by worldwide regulation of the textile industry, undertaken to protect against low-wage labor. By the end of 2004, the World Trade Organization removed the remaining quotas in the textile industry. It turns out that in fact Chinese entrepreneurs have been developing their own cashmere manufacturing industry over the past ten years. They have been helped in part by the low capital costs of entry, as well as the plentiful labor pool in China. A joint venture between a Scottish firm and a Chinese firm in the mid-1990s likely hastened the transfer of manufacturing skills from Scotland to China.
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The Dynamics of Trade: Cashmere
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We can ask whether the Cashmere: Made in Scotland label will keep its cachet or eventually fade away in the face of continual Chinese advances in the cashmere industry.
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As Chinese workers develop skills, Chinese firms will expand up market. As these skills improve, Chinese workers will witness an increase in wages. As Chinese firms produce more cashmere, market demand for cashmere in China is likely to grow. Scottish firms will face continual pressure to cut costs and innovate. As the price of cashmere products falls in the lower end of the market, more consumers worldwide will be able to afford these soft sweaters and scarves.
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Chapter Summary
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Voluntary exchange is a positive sum game, meaning that both parties to a transaction can gain. These gains arise because of comparative advantage. There are some practical constraints on trade. First, every transaction involves costs; and second, production is governed by increasing costs and diminishing returns. Even though overall wealth is enhanced by exchange, there are losses for some individuals and groups.
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Chapter Summary
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When countries trade many commodities, the terms of trade are defined as the average price of exports divided by the average price of imports. The most common forms of trade restrictions are tariffs and quotas. Tariffs generate revenues while driving a wedge between a products domestic price and its price on the world market. When a tariff is imposed on a product, its price will rise.
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Chapter Summary
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Quotas restrict the quantity of imports into a country. Quotas have much the same effect as tariffs, except that they do not generate revenues for the government. The traditional economic arguments against free trade include the following: infant industries, antidumping, protection against lowcost labor, and national defense. Globalization arguments against free trade include domestic employment, the environment, and working conditions in developing nations.
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