Trading with the World

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CHAPTER
Trading with the World
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After studying this chapter you will be able to

• Describe the trends and patterns in international
  trade
• Explain comparative advantage and explain why all
  countries can gain from international trade
• Explain why international trade restrictions
  reduce the volume of imports and exports and
  reduce our consumption possibilities
• Explain the arguments that are used to justify
  international trade restrictions and show how
  they are flawed
• Explain why we have international trade
  restrictions

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Silk Routes and Sucking Sounds

• Since ancient times, people have expanded trading
  as far as technology allowedMarco Polos silk
  route between Europe and China is an example.
• Many people fear free trade and some predicted a
  giant sucking sound as jobs were transferred
  from high-wage Michigan and Ohio to low-wage
  Mexico under the NAFTA.
• Workers in China earn even less than those in
  Mexico. How can we compete with low-wage China?
• Would it be a good idea to limit imports from
  China and other countries by putting on a tariff
  or a quota imports?

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Patterns and Trends in International Trade

• Imports are the good and services that we buy
  from people in other countries.
• Exports are the goods and services we sell to
  people in other countries.

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Patterns and Trends in International Trade

• Trade in Goods
• Manufactured goods represent 55 percent of U.S.
  exports and 68 percent of U.S. imports.
• Raw materials and semi-manufactured materials
  represent 14 percent of U.S. exports and 15
  percent of U.S. imports.
• Agricultural products account for only 8 percent
  of U.S. exports and 4 percent of U.S. imports.
• The largest U.S. export and import items are
  capital goods and automobiles.

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Patterns and Trends in International Trade

• Trade in Services
• International trade in services such as travel,
  transportation, and insurance is large and
  growing.
• Geographical Patterns of International Trade
• The United States trades with countries all over
  the world, but its biggest trading partner is
  Canada with 20 percent of exports going to Canada
  and 17 percent of imports coming from Canada.
• Other U.S. trading partners are Japan, the
  European Union, and Latin America.

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Patterns and Trends in International Trade

• Trends in the Volume of Trade
• In 1960, the United States exported 3.5 percent
  of its total output and imported 4 percent of the
  total amount that Americans spent on goods and
  services.
• In 2006, the United States exported 10 percent of
  its total output and imported 15 percent of the
  total amount that Americans spent on goods and
  services.

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Patterns and Trends in International Trade

• Net Exports and International Borrowing
• The value of exports minus imports is called net
  exports.
• In 2006, U.S. net exports were 780 billion.
• When a country imports more than it exports, it
  must borrow from foreigners or sell some of its
  assets to foreigners.
• When a country exports more than it imports, it
  lends to foreigners or buy some of their assets.

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The Gains from International Trade

• Comparative advantage is the fundamental force
  that generates trade between nations.
• The basis for comparative trade is divergent
  opportunity costs between countries.
• Nations can increase the consumption of goods and
  services when they allocate resources to the
  production of those goods and services for which
  they have a comparative advantage.

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The Gains from International Trade

• Opportunity Cost in Farmland
• Figure 20.1 shows the production possibilities
  frontier for an imaginary country called
  Farmland.
• Without international trade, Farmland produces
  and consumes 15 billion bushels of grain and 8
  million cars at point A.

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The Gains from International Trade

• At point A,
• the opportunity cost of a car is 9,000 bushels of
  grain.

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The Gains from International Trade

• Opportunity Cost in Mobilia
• Figure 20.2 shows the production possibilities
  frontier for another imaginary country called
  Mobilia.
• Without international trade, Mobilia produces and
  consumes 18 billion bushels of grain and 4
  million cars at point A'.

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The Gains from International Trade

• At point A ',
• the opportunity cost of a car is 1,000 bushels of
  grain.

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The Gains from International Trade

• Comparative Advantage
• Cars are cheaper for Mobilia to produce than for
  Farmland because less grain is given up to
  produce each car.
• Grain is cheaper for Farmland to produce than for
  Mobilia because fewer cars are given up to
  produce each bushel.
• A country has a comparative advantage in
  producing a good if it can produce that good at a
  lower opportunity cost than any other country.
• Farmland has a comparative advantage in producing
  grain, and Mobilia has a comparative advantage in
  producing cars.

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The Gains from International Trade

• The Gains from Trade Cheaper to Buy Than to
  Produce
• If Mobilia bought grain for the price that
  Farmland produces it, Mobilia could buy 9,000
  bushels of grain for 1 cara much lower price
  than the opportunity cost of producing grain in
  Mobilia.
• If Farmland bought cars for what Mobilia pays for
  them, Farmland could buy 1 car for 1,000 bushels
  of graina much lower price than the opportunity
  cost of producing cars in Farmland.

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The Gains from International Trade

• The Terms of Trade
• The quantity of grain that Farmland must pay
  Mobilia for a car is called Farmlands terms of
  trade with Mobilia.
• Figure 20.3 shows how the forces of international
  demand and supply determine the terms of trade
  and the volume of trade.

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The Gains from International Trade

• With no international trade, Mobilia can produce
  a car for 1,000 bushels of grain, so at that
  price, it plans to sell no cars to Farmland.
• But as the price rises above 1,000 bushels of
  grain per car the quantity of cars supplied by
  Mobilia increases.

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The Gains from International Trade

• With no international trade, Farmland can produce
  a car for 9,000 bushels of grain, so at that
  price, it plans to buy no cars from Mobilia.
• But as the price falls below 9,000 bushels of
  grain per car the quantity of cars demanded by
  Farmland increases.

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The Gains from International Trade

• The equilibrium terms of trade (price) is 3,000
  bushels of grain per car and 4 million cars are
  exported by Mobilia and imported by Farmland.

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The Gains from International Trade

• Balanced Trade
• The number of cars exported by Mobilia equals the
  number of cars imported by Farmland.
• Farmland pays Mobilia with 12 billion bushels of
  grain(4 million cars multiplied by 3,000 bushels
  for each car).
• Mobilia imports and Farmland exports 12 billion
  bushels of grain. Trade is balanced.
• For each country, the value of exports equals the
  value of imports4 million cars are worth the
  same as 12 billion bushels of grain.

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The Gains from International Trade

• Changes in Production and Consumption
• Farmland buys cars at a price that is lower than
  it can produce cars itself, and sells its grain
  at a higher price.
• Mobilia buys grain at a price that is lower than
  it can produce the grain itself, and sells its
  cars at a higher price.
• Both countries gain from international trade.
• Each PPF illustrates the production possibilities
  of a country, but it does not show the
  consumption possibilities when the country
  engages in international trade.

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The Gains from International Trade

• Figure 20.4 shows how both countries gain from
  trade.

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The Gains from International Trade

• Calculating the Gains from Trade
• Farmland increase its consumption of both cars
  and grain.
• Farmland decreases car production and increases
  grain production until its own opportunity cost
  of producing a car equals the world terms of
  trade and exchanges grain for cars at those terms
  of trade.
• Mobilia increases its consumption of both cars
  and grain.
• Mobilia increases car production and decreases
  grain production until its own opportunity cost
  of producing a car equals the world terms of
  trade and exchanges cars for grain at those terms
  of trade.

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The Gains from International Trade

• Gains for Both Countries
• Both countries gain by consuming output
  combinations outside their respective production
  possibilities frontier.
• Trade does not create a winner and a loser.
• Both countries gain.

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The Gains from International Trade

• Gains from Trade in Reality
• Gains from trade occur in the real global
  economy.
• The United States buys TVs and DVDs from Korea,
  machinery from Europe, and fashion goods from
  Hong Kong and in exchange for machinery, grain,
  airplanes, computers, and financial services.
• All countries gain from this trade.
• The combination of diverse preferences and
  economies of scale create comparative advantages
  that generate a large volume of international
  trade in similar but differentiated products.

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International Trade Restrictions

• Governments restrict international trade to
  protect domestic producers from competition by
  using two main tools
• 1. Tariffs
• 2. Nontariff barriers
• A tariff is a tax that is imposed by the
  importing country when an imported good crosses
  its international boundary.
• A nontariff barrier is any action other than a
  tariff that restricts international trade.

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International Trade Restrictions

• The History of U.S. Tariffs
• Figure 20.5 shows the U.S. average tariff rate
  since 1930.

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International Trade Restrictions

• General Agreement on Tariffs and Trade (GATT) is
  an agreement between nations to have a series of
  trade negotiations, or rounds, to reduce
  tariffs on international trade.
• Rounds of the GATT occurred in the 1960s, late
  1970s, 1980s, and late 1990s and have resulted in
  gradual decline in the average tariff rate. The
  current Doha Round has made little progress.
• The Uruguay round was the most ambitious and lead
  to the creation of the World Trade Organization
  (WTO).
• WTO membership brings greater obligations to
  follow the GATT rules governing trade.

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International Trade Restrictions

• In 1994, the United States became party to the
  North American Free Trade Agreement (NAFTA),
  under which trade barriers between Canada,
  Mexico, and the United States are to be virtually
  eliminated after 15 years.
• The European Union (EU) is an organization of
  European countries that have agreed to eliminate
  trade barriers among them.
• The Asia-Pacific Economic group (APEC) is another
  agreement to reduce trade barriers among East
  Asian countries, including China.

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International Trade Restrictions

• How Tariffs Work
• Tariffs increase the price that consumers of the
  importing country must pay for imported goods or
  services.
• Figure 20.6 uses the Farmland and Mobilia example
  to illustrate the effects of a tariff on car
  imports into Farmland.

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International Trade Restrictions

• The supply of cars to Farmland decreases because
  the tariff must be added to the price at which
  Mobilia is willing to supply a given quantity.
• The price rises, the quantity falls,
• the government collects the tariff revenue.
• Exports change by the same amount as imports.

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International Trade Restrictions

• Nontariff Barriers
• The two main types of nontariff barriers are
• A quota is a quantitative restriction on the
  import of a particular good, which specifies the
  maximum amount of the good that may be imported
  in a given period of time.
• A voluntary export restraint (VER) is an
  agreement between two governments in which the
  government of the exporting country agrees to
  restrain the volume of its own exports.

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International Trade Restrictions

• How Quotas and VERs Work
• Figure 20.7 illustrates the effects of a quota on
  cars imported into Farmland.
• The quota limits the quantity that may be
  imported.
• The domestic price rises.
• Importers of cars make a profit.

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International Trade Restrictions

• A quota can generate the same outcome as a tariff
  but with a quota, the importer makes an economic
  profit equal to the tariff revenue that the
  government receives with a tariff.
• A VER is similar to a quota except that the
  exporter captures the economic profit.

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The Case Against Protection

• Despite the fact that free trade promotes
  prosperity for all countries, trade is
  restricted.
• It is often argued that international trade
  should be restricted to
• Protects national security
• Protect infant industries
• Punish dumping
• None of these arguments bear scrutiny.

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The Case Against Protection

• Other common arguments for protection are that it
• Saves jobs
• Allows us to compete with cheap foreign labor
• Brings diversity and stability to our economy
• Penalizes nations with lax environmental
  standards
• Protects national culture
• Prevents rich nations from exploiting poor ones

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The Case Against Protection

• The National Security Argument
• The idea that a country must protect the
  industries that produce defense equipment and
  supply raw material to these industries.
• This argument does not withstand close scrutiny.
• In time of war, no industry does not contribute
  to national defense.

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The Case Against Protection

• The Infant-Industry Argument
• The infant-industry argument is that it is
  necessary to protect a new industry from import
  competition to enable it to grow into a mature
  industry that can compete in world markets.
• This argument is based on the concept of dynamic
  competitive advantage, which can arise from
  learning-by-doing.
• Learning-by-doing is a powerful engine of
  productivity growth, but this fact does not
  justify protection.

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The Case Against Protection

• The Dumping Argument
• Dumping occurs when foreign a firm sells its
  exports at a lower price than its cost of
  production.
• Dumping is seen as a justification for a tariff
  to prevent a foreign firm driving domestic firms
  out of business and then raising its price.
• This argument does not justify protection
  because
• It is virtually impossible to determine a firms
  costs
• If there was a natural global monopoly, it would
  be more efficient to regulate it than to impose
  a tariff against it.

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The Case Against Protection

• Saves Jobs
• The idea that buying foreign goods costs domestic
  jobs is wrong.
• Free trade destroys some jobs and creates other
  better jobs.
• Free trade also increases foreign incomes and
  enables foreigners to buy more domestic
  production.
• Protection to save particular jobs is very costly.

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The Case Against Protection

• Allows us to Compete with Cheap Foreign Labor
• The idea that a high-wage country cannot compete
  with a low-wage country is wrong.
• Low-wage labor is less productive than high-wage
  labor.
• And wages and productivity tell us nothing about
  the source of gains from trade, which is
  comparative advantage.

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The Case Against Protection

• Brings Diversity and Stability
• The idea that protection brings diversity of
  production and greater stability of income is
  wrong.
• A nation can achieve diversity and stability
  through its international investments.

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The Case Against Protection

• Penalizes Lax Environmental Standards
• The idea that protection is good for the
  environment is wrong.
• Free trade increases incomes and poor countries
  have significantly lower environmental standards
  than rich countries.
• These countries cannot afford to spend as much on
  the environment as a rich country can and
  sometimes they have a comparative advantage at
  doing dirty work, which helps the global
  environment achieve higher environmental
  standards.

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The Case Against Protection

• Protects National Culture
• The idea that trade restrictions protect the
  national culture is wrong.
• This argument is heard in Canada and European
  countries.
• Many countries are afraid of the
  Americanization of their culture through the
  prominence of American films, television
  programs, art, literature, and even cuisine in
  world markets.
• Protecting cultural industries is a form of
  rent seeking and the surest way to eliminate a
  national culture.

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The Case Against Protection

• Prevents Rich Countries from Exploiting Poorer
  Countries
• The idea that trade restrictions prevent rich
  countries from exploiting poorer countries is
  wrong.
• Free trade is the best way of raising wages and
  improving working conditions in poor countries.

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The Case Against Protection

• The most compelling argument against protection
  is that it invites retaliation.
• We saw retaliation to the Smoot-Hawley Act in the
  United States during the Great Depression.
• And we see it today as the world reacts to high
  U.S. tariffs on steel and agriculture.

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Why Is International Trade Restricted?

• The two key reasons why international trade is
  restricted are
• Tariff revenue
• Rent seeking

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Why Is International Trade Restricted?

• Tariff Revenue
• It is costly for governments to collect taxes on
  income and domestic sales.
• It is cheaper for governments to collect taxes on
  international transactions because international
  trade is carefully monitored.
• This source of revenue is especially attractive
  to governments in developing nations.

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Why Is International Trade Restricted?

• Rent Seeking
• Rent seeking is lobbying and other political
  activities that seek to capture the gains from
  trade.
• Despite the fact that protection is inefficient,
  governments respond to the demands of those who
  gain from protection and ignore the demands of
  those who gain from free trade because protection
  brings concentrated gains and diffused losses.

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Why Is International Trade Restricted?

• Compensating Losers
• The gains from free trade exceed the losses, and
  sometimes free trade agreements address the issue
  of the distribution of gains from trade by
  compensating those who lose from free trade.
• 1. The cost of identifying the losers form free
  trade and compensating them would be enormous.
• 2. Difficult to know if the person is a loser
  from free trade or some other reason.
• Because we do not compensate losers,
  protectionism remains popular.

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THE END