17 key topics
Tariffs/ Quotas
Opportunity Cost, Comparative Advantage
I.
Foreign Trade
A. In a “closed economy,” GDP=C+I+G
If there is absolutely no exporting or importing, the country is an “autarky” maintaining
economic self-sufficiency.
B. In an open economy, GDP= C+I+G+NX
In the US, Export-Imports (X-M=NX) have been negative since 1980. That table has
separated Net payments for services and added that value to net merchandise (goods) traded
to get Net Foreign Trade. In the formula X-M=NX, where X=exports and M=imports, the
variables include both goods and services.
NX is frequently referred to as the “trade deficit” or the “current account deficit.” If one
adds to NX the net unilateral transfers (Foreign investment in U.S. financial and physical
capital-US investment in foreign assets) the result is the “current account balance.”
“Domestic” refers to economic actions or actors within the U.S.
C. Primary causes of the negative (“unfavorable”) NX
1. Strong Dollar
a. There are currency markets which reflect the demand for dollars from those
who would trade other currency in order to invest in U.S. assets, and there is a supply
of dollars from those who hold them but would rather hold a different currency (e.g.
Yen) for investment in that country’s assets (e.g. Japan).
b. Currency trading is driven by countries with high asset returns (which can
include high interest rates), stable and growing national economies, rising asset
values (includes stocks and real estate) and low inflation. Therefore the strong dollar
as compared to other currencies is a reflection of the U.S. economy exhibiting these
tendencies.
c. The currency strength is directly related to imports and inversely related to
exports. Just like the foreign investor who wants a U.S. asset must first buy dollars
with the foreign currency, the foreign customer who may want a U.S. made good (an
export from us, and import to that country) must pay a higher price when the dollar is
strong.
i. This is because the U.S. producers want to be paid in dollars, and if the
dollar has risen in value, they don’t adjust their prices for any foreign currencies that
have not similarly “appreciated in value.” Therefore if the foreign currency
maintained value as the U.S. dollar appreciates, the U.S. goods (and services) are
more expensive to foreign buyers.
ii. The higher cost of American-made goods will cause some prospective
foreign customers to not buy our exports (X declines) in favor of domestic producers
or imports from another country.
While X fell when $ rose, the relationship between $ and M is direct. When the
dollar is strong and rising, more foreign currency can be bought with a given dollar.
A German carmaker wants to be paid in Euros, so Americans will happily import
more German cars (and all sorts of other foreign-made goods) in response to the
dollars appreciation.
To make clear some terminology, appreciation is the opposite of inflation, which
is when a currency weakens. However, it is not quite so far down the road as
“deflation” which would be evident if the price level fell for goods in this country.
This is because the dollar appreciates (numerically) by maintaining lower inflation
than foreign countries. While the U.S. inflation rate generally hovers around 2-3%,
our currency is indeed appreciating because trading partners have averaged
significantly higher rates of inflation.
B. The 1980’s witnessed tax cuts which worsened fiscal deficits but spurred
spending, including on imports.
II.
Gains from Trade
A. “Absolute Advantage” is when a nation has lower opportunity costs in the production
of all tradable goods than its trading partner.
B. “Comparative Advantage” is when a nation has lower opportunity costs in the
production of some goods, but higher costs in terms of resources per unit of output than
its trading partner in the production of other goods.
C. Example of Comparative Advantage. Take straight-line PPC’s of the U.S. and trading
partner Honduras for the 2 goods, tractors (in 1000’s) and bananas (in tons). When U.S.
(tractors, bananas) = (50,0) then resources are shifted toward banana harvesting to
produce 5 tons, production of tractors drops by 10 (thousand). This 5:10 ratio is the MRT
(marginal rate of transformation) and could be reduced to .5:1
Bananas:Tractors, while the ratio in Honduras is 4:1
The cost of producing one tractor in the U.S. is half a ton of Bananas. The opportunity
cost of building the same tractor in Honduras is 4 tons. It’s cheaper to build tractors here,
and Honduras has the comparative advantage in bananas. The two nations should
specialize and trade. Fig 2-7 on p. 31 illustrates.
D. “Terms of Trade”
These MRT’s set the limits for the “terms of trade” which is a range of prices (still given
in terms of the other good) which will be accepted for the trans-national commerce. In
this case, the U.S. will accept no fewer than a half a ton of Bananas (assuming negligible
shipping costs here) per thousand tractors, and Honduras must receive at least one
thousand tractors per 4 tons of bananas.
Where in this range the terms of trade will settle depends on the relative demand and
supply of each good in either country, as well as the availability of substitutes.
E. The PPC shift
By specializing in and exporting goods in which they have comparative advantage, and
importing those in which they have a comparative disadvantage, the world output level
(PPC for both countries together) is increased, indicated by a right-shift. Individual
countries also enjoy a right-shifting PPC through trade based on comparative advantage,
although technically it is depicted as a “pivot” where they consume more of the good that
was their comparative disadvantage.
F. Sources of Comparative Advantage
1. Natural Resources, including mining, petroleum, natural gas, wildlife.
2. Climate and ground layout may be optimal for some industries and
unworkable for others.
3. The relative supplies of the Factors of Production.
For example, a highly industrialized society will tend to have comparative advantage in
manufactured goods because they are produced using capital-intensive processes. A country
with a vast labor pool and very little capital will tend to have comparative advantage in laborintensive industries.
III. Concerns
A. One characteristic of a lot of trade, especially when the countries vary greatly in
wealth, is that “gains” (benefits to society) are spread out while “losses” such as failing domestic
industries and the concurrent loss of jobs are usually “concentrated.”
In other words, a local area may become a ghost town, or a city may have to find a new
industry to rely on for jobs and tax revenue, but the lower prices from cheap imports will allow a
much broader range of people across the county enjoy somewhat more consumption. It is for this
reason that anti-trade pressures can be applied by groups who feel they have endured
concentrated losses, but there isn’t much organization among the broader population to fight for
small but widespread gains in the form of lower-priced goods.
1. Solutions to remedy these concentrated losses: Fiscal or Monetary policy that
is expansionary, and job-retraining programs.
B. Competition is assumed on both sides of the exchange for either good under the
comparative advantage analysis.
C. Accurate prices are essential. This means externalities are incorporated into the cost
structure.
D. Prices also must reflect true scarcity and demand in a given country. This means
distortions in the price of a good are not introduced by the government propping up
the industry.
E. “Protectionism”: efforts by governments to protect industries from competing
imports. Some methods are:
1. Tarriffs: a tax (or “levy”) on imported goods of a specified type or national
origin. Domestic producers benefit. Domestic consumers of the good lose out, as they
have to pay higher prices, and foreign producers lose sales.
a. How “Elasticity” affects the burden of the tariff.
Elasticity is the change in Quantity that results from a Change in Price. The steep demand curve
is called inelastic. In this diagram, the higher price after the tariff is largely absorbed by the
consumers, and quantity does not fall much. This is characteristic of goods which are viewed as
necessities or have few substitutes.
b. On the other hand, for an “elastic” Demand curve, rather flat, it reflects a
significant decline in quantity demanded for just a small increase in price. These sorts of goods
are viewed by consumers as strictly optional purchases, and have many available substitutes. In
this case, the burden of the tariff is mostly on the foreign producer, while in the inelastic case,
most of the burden is on the domestic consumers.
c. Another party that may lose out is other domestic businesses in related
industries. For example, the steel tariffs imposed in the last few year saved jobs in the U.S. steel
industry but cost more jobs in industries that were relying on (now higher-priced) steel.
d. Another party that benefits is the government, which collects more tax revenue
in the form of the tariff, and even more revenue correlating with the improved fortunes of the
domestic producers in the protected industry.
2. Quotas
A maximum quantity of imports allowable for a certain good. This has the same effects as a
tariff, and is equally dependent on demand elasticity to determine where the burden
predominantly falls, but a big difference is the lack of tax revenue relative to a tariff.
3. Embargoes
A prohibition against importation of a country’s goods. While other protectionist measures are
usually responses to economic conditions (like a flood of inexpensive imports of a certain type)
the embargo is usually a response to a political situation. It is a condemnation that sends a
message to a foreign government, and may be accompanied by restrictions on the types of goods
that will be legal for export to that country.
4. “Rational Ignorance”
The question is raised, why would domestic consumers accept quotas and other governmentmaintained distortions in goods prices (like agricultural subsidies) when they result in higher
market prices, to the benefit of some producers. “Rational Ignorance” argues that when benefits
are concentrated (in this case, in the profits of producers) and losses are spread thin across the
population, it is not seen as worth people’s time to resist the protectionist measures.
The same principle is at work when the losses are concentrated in certain industries, where there
is an intense motivation to advocate for protectionism, while the society at large enjoying
somewhat lower prices is “rationally ignorant” in finding it not worth their time to resist the
protectionist proposals.
F. Rationales for Protectionism
1. Infant-Industry
A new industry cannot compete with its counterpart in a nation in which that industry
is mature. Problems with this argument include:
a. The difficulty in removing protections once the industry is clearly mature. By
that time, the company may have accumulated some political influence, and
its employees may be great in number and important constituents of elected
officials.
b. Also, direct subsidies are preferable because they make clear what it is costing
to support the industry.
c. Finally, the government, in selecting which new industries to support and
which to ignore, is making a business judgment about industries and their
future viability, which may just result in collapse whenever the protections are
withdrawn.
2. National Security
Defense goods should be made domestically for security reasons. One problem is
this eliminates the possibility of trading with a country that has a comparative advantage
over the U.S. in producing certain defense goods. In order to make firms produce in a
less than maximally efficient way, either protections or direct subsidies may be required.
Again, for their transparency, economists generally favor subsidies over tarriffs.
3. Inexpensive Foreign Labor
U.S. producers in many industries cannot be cost-competitive with foreign producers
due to especially low labor costs. Economists’ responses to this argument are:
a. In many cases, higher wages reflect a higher productivity level. In
microeconomics, one of the methods to analyze whether a firm is maximizing profits
is if it is minimizing costs, which can be shown by an (hourly) wage that is equal to
the value (in additional revenue) of the last hour of labor hired by the firm. The firm
will continue hiring labor until this condition holds, and the equation is written as
W=MRP meaning Wage rate= Marginal (additional unit of) Revenue Product
(produced, by labor in this case).
b. If a labor-intensive country can make the same good for less, then it’s
inefficient for American firms to stay in the industry.
c. Resources to protect a failing industry would be better used to grow an
industry that can compete in the world market.
d. Strictly looking at wages ignores productivity disparities, which have
significant impact on per-unit costs.
4. Macroeconomic Employment or “Beggar-thy-Neighbor”
This argument is based on the concept that the U.S. could use protectionist policies
to “export” some unemployment.
a. One problem is retaliatory tariffs (trading partners respond with protectionist
policies of their own that restrict U.S. exports) which could stir up a back and forth
buildup of such policies, a situation known as a “trade war.”
b. Also the policy here is enacted in response to a slowdown in the U.S. economy
(which caused the unemployment the protectionist policies are meant to solve) so it’s
likely that the Fed will be enacting expansionary monetary policy and the government
some expansionary fiscal policy, all of which stimulate demand and will encourage
domestic producers to increase output. The problem is that a distortion has been
introduced where U.S. firms are specializing not so much based on comparative
advantage but on what industries have the tariff or quota protections, so this introduces
some inefficiency.
5. Retaliation for another country’s protectionist policies.
This argument states that trading nations can be compelled to lower barriers by
enacting protections with the message they will be removed when our trading partner
removes their own protections, or stops “dumping” – flooding the U.S. market with
inexpensive imports.
a. While domestic producers suffer from “dumping,” this dramatic increase in
supply means lower prices for domestic consumers.
6. Protecting Declining Industries
This is based on a similar logic as the Infant-Industry argument, and is subject to
some of the same flaws, such as the government’s need in this situation to identify which
industries are worth supporting with an eye toward their future viability.
IV. Trade Agreements
A. GATT (General Agreement on Trade and Tarriffs) is an agreement between over 100
countries to phase out trade restrictions. The WTO (World Trade Organization) replaced GATT
in 1994 and called upon the liberalization of trade in developing countries in addition to the
developed nations. The WTO provides a forum for dispute settlement and legitimizes
retaliatory tariffs as punishment for a country that is found to have implemented tariffs
unjustifiably.
B. Types of Regional Trade Agreements
Free Trade Agreement – Phase out tariffs and other protections against trade among
member nations
Customs Union – Free trade among member nations and a system of common tariffs
for non-member imports
Ex: Mercosur is the Customs Union formed by several major South American
countries
Common Market – Free trade, common tariffs, and free movement of capital and
labor among member nations
C. NAFTA – North American Free Trade Agreement called for trade between Canada,
the U.S., and Mexico to be free from tariffs by 2008, 15 years from the signing in
1993. The FTAA, or Free Trade Area of the Americas is a proposal to expand free
trade to include South America, but has not been ratified and negotiations are
sporadic but ongoing.
D. The future of free trade - while trends towards greater transnational trade are viewed
by economists as an overall positive development, other possibilities for the future
include:
1. Regional trading blocs that raise protections against non-members
2. A return to command economies
Both these possibilities will limit world production and consumption because they rely on
principles other than comparative advantage to determine division of resources. The command
(central planning) economy, for instance, is much more prone to base trading relationships on
political considerations than the more purely economics-oriented market actors.