International Trade
Introduction
We have learned:

Free trade can make everyone better off (on balance)

Comparative advantage and specialization drive free trade
You will now learn:

Stylized facts about free trade

Determinants of trade

The gains and losses of an exporting country

The gains and losses of an importing country

The effects of a tariff

How import quotas are used to restrict trade

The lessons for trade policy

The arguments for restricting free trade

Trade agreements and the WTO
Volume of world merchandise exports and gross domestic
product, 1950-2010
Exports of LDCs (WTO)
51.7
53.6
Fuels
11.8
13.7
Clothing
9.9
9.2
Food
2010
3.5
4.3
Raw materials
2005
2.3
3.2
Other semi-manufactures
1.3
1.4
Textiles
Others
14.6
0
10
19.4
20
30
40
50
60
Current Account %GDP
2
1
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
0
-1
-2
Current Account %GDP
-3
-4
-5
-6
-7
A current account surplus increases a country's net foreign assets by the corresponding amount,
and a current account deficit does the reverse. Both government and private payments
are included in the calculation. It is called the current account because goods and
services are generally consumed in the current period.
The Determinants of Trade
o Example used throughout the chapter: The market for jet engines/soccer
balls in America.
o The Equilibrium without Trade

If there is no trade, the domestic price in the market will balance
supply and demand.

A new president is elected who is interested in pursuing trade. A
committee of economists is organized to determine the following:

If the government allows trade, what will happen to the price
of engines/balls and the quantity of each sold in the domestic
market?

Who will gain from trade, who will lose, and will the gains
exceed the losses?

Should a tariff (a tax on imported balls) be part of the new
trade policy?
The World Price and Comparative Advantage

The first issue is to decide whether America should import or export jet engines.
o The answer depends on the relative price of engines in America compared
with the price of engines in other countries.
o world price: the price of a good that prevails in the world market for that
good.

If the world price is greater than the domestic price, America should export; if the
world price is lower than the domestic price, America should import.
o Note that the domestic price represents the opportunity cost of producing
in America, while the world price represents the opportunity cost of
producing abroad.
o Thus, if the domestic price is low, this implies that the opportunity cost of
producing in America is low, suggesting that America has a comparative
advantage. If the domestic price is high, the opposite is true.
The Winners and Losers from Trade
o We can use welfare analysis to determine who will gain and who will lose if free
trade begins in America.
o We will assume that, because America would be such a small part of the market,
they will be price takers in the world economy. This implies that they take the
world price as given and must sell (or buy) at that price.
The Gains and Losses of an Exporting Country
o If the world price is higher than the domestic price, America will export engines.
Once free trade begins, the domestic price will rise to the world price.
o As the price of engines rises, the domestic quantity of engines demanded will fall
and the domestic quantity of engines supplied will rise. Thus, with trade, the
domestic quantity demanded will not be equal to the domestic quantity supplied.
Welfare without Trade
o Consumer surplus is equal to: A + B.
o Producer surplus is equal to: C.
o Total surplus is equal to: A + B + C.
Welfare with Trade
o Consumer surplus is equal to: A.
o Producer Surplus is equal to: B + C + D.
o Total surplus is equal to: A + B + C + D.
Changes in Welfare
o Consumer surplus changes by: –B.
o Producer surplus changes by: +(B + D).
o Total surplus changes by: +D.

When a country exports a good, domestic producers of the good are better off
and domestic consumers of the good are worse off.

When a country exports a good, total surplus is increased and the economic
well-being of the country rises.
The Gains and Losses of an Importing Country

If the world price is lower than the domestic price, America will import soccer
balls. Once free trade begins, the domestic price will fall to the world price.

As the price of balls falls, the domestic quantity of balls demanded will rise
and the domestic quantity of balls supplied will fall.

Thus, with trade, the domestic quantity demanded will not be equal to the
domestic quantity supplied.

America will import the difference between the domestic quantity demanded
and the domestic quantity supplied.
Welfare without Trade

Consumer surplus is equal to: A.

Producer surplus is equal to: B + C.

Total surplus is equal to: A + B + C.
Welfare with Trade

Consumer surplus is equal to: A + B + D.

Producer surplus is equal to: C.

Total surplus is equal to: A + B + C + D.
Changes in Welfare

Consumer surplus changes by: +(B + D).

Producer surplus changes by: –B.

Total surplus changes by: +D.

When a country imports a good, domestic consumers of the good are better
off and domestic producers of the good are worse off.

When a country imports a good, total surplus is increased and the economic
well-being of the country rises.
Trade policy is often contentious because the policy creates winners and
losers. If the losers have political clout, the result is often trade
restrictions such as tariffs and quotas.
The Effects of a Tariff
tariff: a tax on goods produced abroad and sold domestically.
o A tariff raises the price above the world price. Thus, the domestic price of
balls will rise to the world price plus the tariff.
o As the price rises, the domestic quantity of balls demanded will fall and the
domestic quantity of balls supplied will rise. The quantity of imports will
fall and the market will move closer to the domestic market equilibrium
that occurred before trade.
Welfare before the Tariff (with trade)

Consumer surplus is equal to: A + B + C + D + E + F.

Producer surplus is equal to: G.

Government revenue is equal to: zero.

Total surplus is equal to: A + B + C + D + E + F + G.
Welfare after the Tariff

Consumer surplus is equal to: A + B.

Producer surplus is equal to: C + G.

Government revenue is equal to: E.

Total surplus is equal to: A + B + C + E + G.
Changes in Welfare

Consumer surplus changes by: –(C + D + E + F).

Producer surplus changes by: +C.

Government revenue changes by: +E.

Total surplus changes by: –(D + F).
Import Quotas: Another Way to Restrict Trade

An import quota is a limit on the quantity of a good that can be produced abroad
and sold domestically.

Import quotas are much like tariffs.
o Both tariffs and quotas raise the domestic price of the good, reduce the
welfare of domestic consumers, increase the welfare of domestic
producers, and cause deadweight losses.
o However, a tariff raises revenue for the government, whereas a quota
creates surplus for license holders.
o A quota can potentially cause a larger deadweight loss than a tariff,
depending on the mechanism used to allocate the import licenses.
Other Trade Restrictions

Product standards
o E.g., German beer purity laws: the only ingredients that can be used in the
production of beer are water, barley and hops.
o Car safety standards
o Environmental protection standards
o Labor protection standards
The Lessons for Trade Policy

If trade is allowed, the price of products will be driven to the world price. If the
domestic price is higher than the world price, the country will become an
importer and the domestic price will fall. If the domestic price is lower than the
world price, the country will become an exporter and the domestic price will rise.

If a country imports a product, domestic producers are made worse off, domestic
consumers are made better off, and the gains of consumers outweigh the losses of
producers. If a country exports a product, domestic producers are made better
off, domestic consumers are made worse off, and the gains of producers outweigh
the losses of consumers.

A tariff would create a deadweight loss because total surplus would fall.
Other Benefits of International Trade

In addition to increasing total surplus, there are several other benefits of
free trade.

These include an increased variety of goods, lower costs through
economies of scale, increased competition, and an enhanced flow of ideas.
The Arguments for Restricting Trade





The Jobs Argument
o
If a country imports a product, domestic producers of the product will have to lay
off workers because they will decrease domestic output when the price declines to
the world price.
o
Free trade, however, will create job opportunities in other industries where the
country enjoys a comparative advantage.
The National-Security Argument
o
Certain industries may produce key resources needed to produce products
necessary for national security.
o
In many of the cases for which this argument is used, the role of the particular
market in providing national security is exaggerated.
The Infant-Industry Argument
o
New industries need time to establish themselves to be able to compete in world
markets.
o
Sometimes older industries argue that they need temporary protection to help
them adjust to new conditions.
o
Even if this argument is legitimate, it is nearly impossible for the government to
choose which industries will be profitable in the future and it is even more
difficult to remove trade restrictions in an industry once they are in place.
The Unfair-Competition Argument
o
It is unfair if firms in one country are forced to comply with more regulations
than firms in another country, or if another government subsidizes the
production of a good.
o
Even if another country is subsidizing the production of a product so that it can
be exported to a country at a lower price, the domestic consumers who import the
product gain more than the domestic producers lose.
The Protection-as-a-Bargaining-Chip Argument
o
Threats of protectionism can make other countries more willing to reduce the
amounts of protectionism they use.
o
If the threat does not work, the country has to decide if it would rather reduce the
economic well-being of its citizens (by carrying out the threat) or lose credibility
in negotiations (by reneging on its threat).
Case Study: Trade Agreements and the World Trade
Organization

Countries wanting to achieve freer trade can take two approaches to cutting trade
restrictions: a unilateral approach or a multilateral approach.

A unilateral approach occurs when a country lowers its trade restrictions on its
own. A multilateral approach occurs when a country reduces its trade restrictions
while other countries do the same.

The North America Free Trade Agreement (NAFTA) and the General Agreement
on Tariffs and Trade (GATT) are multilateral approaches to reducing trade
barriers.

The rules established under GATT are now enforced by the World Trade
Organization (WTO).

The functions of the WTO are to administer trade agreements, provide a forum
for negotiation, and handle disputes that arise among member countries.
NAFTA
 Largest trade bloc in world
 Negotiations started in 1986; signed in 1992; implemented 1994
 Within 10 years, basically eliminated all trade and investment barriers
GATT
 Lasted from 1946 until 1993
 Replaced by WTO, which left language of GATT in effect
WTO
 It is an organization for trade opening. It is a forum for governments to negotiate
trade agreements. It is a place for them to settle trade disputes. It operates a
system of trade rules. Essentially, the WTO is a place where member
governments try to sort out the trade problems they face with each other.