CHAPTER
9
Application: International Trade
Goals
in this chapter you will
Consider what determines whether a country imports or exports
a good
Examine who wins and who loses from international trade
Learn that the gains to winners from international trade exceed
the losses to losers
Analyze the welfare effects of tariffs
Examine the arguments people use to advocate trade restrictions
Outcomes
after accomplishing
these goals, you
should be able to
Determine whether a country imports or exports a good if the
world price is greater than the before-trade domestic price
Show that the consumer wins and the producer loses when a
country imports a good
Use consumer and producer surplus to show that the gains of
the consumer exceed the losses of the producer when a country
imports a good
Show the deadweight loss associated with a tariff
Defeat the arguments made in support of trade restrictions
85
86
Chapter 9 Application: International Trade
Strive for a Five
The material covered in Chapter 9 is tested on both the micro- and macroeconomics test.
Specifically:
■■ Government policies that restrict trade
1. Tariffs
2. Import quotas
For microeconomics:
■■ The effect of these government policies on the world market price and quantity
Key Terms
■■
■■
■■
World price—The price of a good that prevails in the world market for that good
Price takers—Market participants that cannot influence the price so they view the
price as given
Tariff—A tax on goods produced abroad and sold domestically
Chapter Overview
Context and Purpose
Chapter 9 is the third chapter in a three-chapter sequence dealing with welfare economics.
Chapter 7 introduced welfare economics—the study of how the allocation of resources
affects economic well-being. Chapter 8 applied the lessons of welfare economics to
taxation. Chapter 9 applies the tools of welfare economics from Chapter 7 to the study of
international trade, a topic that was first introduced in Chapter 3.
The purpose of Chapter 9 is to use our knowledge of welfare economics to address the
gains from trade more precisely than we did in Chapter 3 when we studied comparative
advantage and the gains from trade. We will develop the conditions that determine whether
a country imports or exports a good and discover who wins and who loses when a
country imports or exports a good. We will find that when free trade is allowed, the gains
of the winners exceed the losses of the losers. Because there are gains from trade, we will
see that restrictions on free trade reduce the gains from trade and cause deadweight losses
similar to those generated by a tax.
Chapter Review
Introduction This chapter employs welfare economics to address the following questions:
■■ How does international trade affect economic well-being?
■■ Who gains and who loses from free international trade?
■■ How do the gains from trade compare to the losses from trade?
The Determinants of Trade
In the absence of international trade, a market generates a domestic price that equates
the domestic quantity supplied and domestic quantity demanded in that market. The
world price is the price of the good that prevails in the world market for that good. Prices
represent opportunity costs. Therefore, comparing the world price and the domestic
price of a good before trade indicates whether a country has the lower opportunity cost
of production and, thus, a comparative advantage in the production of a good or if other
countries have a comparative advan­tage in the production of the good.
Chapter 9
1
Domestic
supply
Price
Price after
trade
A
B
World
price
D
Price before
trade
C
Domestic
demand
QS
QD
Quantity
{
EXHIBIT
aPPliCation: international trade
exports
■■
■■
If the world price is above the domestic price for a good, the country has a
comparative advantage in the production of that good and that good should be
exported if trade is allowed.
If the world price is below the domestic price for a good, foreign countries have
a comparative advantage in the production of that good and that good should be
imported if trade is allowed.
The Winners and Losers from Trade
Assume that the country being analyzed is a small country and is, therefore, a price taker
on world markets. This means that the country takes the world price as given and cannot
influence the world price.
Exhibit 1 depicts a situation where the world price is higher than the before-trade
domestic price. This country has a comparative advantage in the production of this good. If
free trade is allowed, the domestic price will rise to the world price and it will export the
difference between the domestic quantity supplied and the domestic quantity demanded.
With regard to gains and losses to an exporting country from trade, before-trade
consumer sur plus was A + B and producer surplus was C, so total surplus was A + B + C.
After trade, consumer surplus is A and producer surplus is B + C + D (the area below the
price and above the supply curve). Total surplus is now A + B + C + D for a gain of area
D. This analysis generates two conclusions:
■■ When a country allows trade and becomes an exporter of a good, domestic producers
are better off and domestic consumers are worse off.
■■ Trade increases the economic well-being of a nation because the gains of the winners
exceed the losses of the losers.
87
aPPliCation: international trade
EXHIBIT
2
Domestic
supply
A
Price before
trade
B
Price after
trade
D
World
price
C
Domestic
demand
QS
QD
Quantity
{
Chapter 9
Price
88
imports
Exhibit 2 depicts a situation where the world price is lower than the before-trade
domestic price. Other countries have a comparative advantage in the production of this
good. If free trade is allowed, the domestic price will fall to the world price, and it will
import the difference between the domestic quantity supplied and the domestic quantity
demanded.
With regard to gains and losses to an importing country from trade, before-trade
consumer sur plus was A and producer surplus was B + C, so total surplus was A + B + C.
After trade, consumer surplus is A + B + D (the area below the demand curve and above
the price) and producer surplus is C. Total surplus is now A + B + C + D for a gain of area
D. This analysis generates two conclusions:
■■ When a country allows trade and becomes an importer of a good, domestic
consumers are better off and domestic producers are worse off.
■■ Trade increases the economic well-being of a nation because the gains of the winners
exceed the losses of the losers.
Trade can make everyone better off if the winners compensate the losers. Compensation
is rarely paid, so the losers lobby for trade restrictions, such as tariffs.
Tariffs restrict international trade. A tariff is a tax on goods produced abroad and sold
domestically. Therefore, a tariff is placed on a good only if the country is an importer of
that good. A tariff raises the price of the good, reduces the domestic quantity demanded,
increases the domestic quantity supplied, and, thus, reduces the quantity of imports. A tariff
moves the market closer to the no-trade equilibrium.
A tariff increases producer surplus and government revenue but reduces consumer
surplus by a greater amount than the increase in producer surplus and government
revenue. Therefore, a tariff creates a deadweight loss because total surplus is reduced. The
deadweight loss comes from two sources. The increase in the price due to the tariff causes
the production of units that cost more to produce than the world price (overproduction)
and causes consumers to fail to consume units where the value to the consumer is greater
than the world price (underconsumption).
An import quota sets a limit on the quantity of a good that can be produced abroad
and sold domestically. To accomplish this, a government can distribute a limited number
Chapter 9 Application: International Trade
of import licenses. As with a tariff, an import quota reduces the quantity of imports, raises
the domestic price of the good, decreases the welfare of domestic consumers, increases the
welfare of domestic producers, and causes deadweight losses. It moves the market closer to
the no-trade equilibrium.
Note that the results of a tariff and an import quota are nearly the same except that the
govern­ment collects revenue from a tariff. If the import licenses are given away, the license
holders earn the surplus generated from the world price being below the domestic price. If
the government sells the import licenses for the maximum possible amount, it will collect
revenue equal to the tariff revenue and a tariff and a quota become identical. If quotas are
“voluntary” in the sense that they are imposed by the exporting country, the revenue from
the quota accrues to the foreign firms or governments.
Tariffs cause deadweight losses. Therefore, if economic efficiency is a policy goal,
countries should allow free trade and avoid using tariffs.
Free trade offers benefits beyond efficiency. Free trade increases variety for consumers,
allows firms to take advantage of economies of scale, makes markets more competitive, and
facilitates the spread of technology.
The Arguments for Restricting Trade
Opponents of free trade (often producers hurt by free trade) offer the following arguments
in support of trade restrictions:
■■
The Jobs Argument Opponents of free trade argue that trade destroys domestic
jobs. However, while free trade does destroy inefficient jobs in the importing sector,
it creates more efficient jobs in the export sector, industries where the country has
a comparative advantage. This is always true because each country has a comparative
advantage in the production of something.
■■
The National-Security Argument Some industries argue that their product
is vital for national security so it should be protected from international competition.
The danger of this argument is that it runs the risk of being overused, particularly
when the argument is made by representatives of industry rather than the defense
establishment.
■■
The Infant-Industry Argument New industries argue that they need
temporary protection from international competition until they become mature
enough to compete. However, there is a problem choosing which new industries
to protect, and once protected, temporary protection often becomes permanent. In
addition, industries government truly expects to be competitive in the future don’t
need protection because the owners will accept short-term losses.
■■
The Unfair-Competition Argument Opponents of free trade argue that
other countries provide their industries with unfair advantages such as subsidies, tax
breaks, and lower environmental restrictions. However, the gains of consumers in the
importing country will exceed the losses of the producers in that country, and the
country will gain when importing subsidized production.
■■
The Protection-as-a-Bargaining-Chip Argument Opponents of free trade
argue that the threat of trade restrictions may result in other countries lowering their
trade restrictions. However, if this does not work, the threatening country must back
down or reduce trade—neither of which is desirable.
When countries choose to reduce trade restrictions, they can take a unilateral approach
and re­move trade restrictions on their own. Alternatively, they can take a multilateral
approach and reduce trade restrictions along with other countries. Examples of the
multilateral approach are NAFTA and GATT. The rules of GATT are enforced by the
WTO. The multilateral approach has advantages in that it provides freer overall trade
because many countries do it together, and thus, it is sometimes more easily accomplished
89
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Chapter 9 Application: International Trade
politically. However, it may fail if negotiations between countries break down. Many
economists suggest a unilateral approach because there will be gains to the domestic
economy and this will cause other countries to emulate it.
Conclusion
Economists overwhelmingly support free trade. Free trade between states in the United
States im­proves welfare by allowing each area of the country to specialize in the
production of goods for which they have a comparative advantage. In the same manner,
free trade between countries allows each country to enjoy the benefits of comparative
advantage and the gains from trade.
Helpful Hints
1. Countries that restrict trade usually restrict imports rather than exports. This is because
produc­ers lose from imports and gain from exports, and producers are better organized
to lobby the government to protect their interests. For example, when a country
imports a product, consum­ers win and producers lose. Consumers are less likely to
organize and lobby the government than the affected producers so imports may be
restricted. When a country exports a product, producers win and consumers lose.
Yet again, consumers are less likely to organize and lobby the government to restrict
exports so exports are rarely restricted.
2. The overwhelming majority of economists find no sound economic argument in
opposition to free trade. The only argument against free trade that may not be defeated
on economic grounds is the “national-security argument.” This is because it is the
only argument against free trade that is not based on economics but rather is based on
other strategic objectives.
3. A prohibitive tariff or import quota is one that is so restrictive that it returns the
domestic market to its original no-trade equilibrium. This occurs if the tariff is greater
than or equal to the dif­ference between the world price and the no-trade domestic
price or if the import quota is set at zero.
Self-Test
Multiple-Choice Questions
1. A tax on an imported good is called a
a. quota.
b. tariff.
c. supply tax.
d. trade tax.
e. embargo.
2. When a country allows trade and becomes an exporter of a good,
a. the gains of the domestic producers of the good exceed the losses of the domestic
consumers of the good, and total surplus increases.
b. the gains of the domestic consumers of the good exceed the losses of the
domestic producers of the good.
c. the losses of the domestic producers of the good exceed the gains of the domestic
consumers of the good.
d. the losses of the domestic consumers of the good exceed the gains of the
domestic producers of the good.
e. the gains of the domestic producers of the good exceed the losses of the domestic
consumers of the good, and total surplus decreases.
Chapter 9 Application: International Trade
Price
Figure 9-1
P0
Domestic
Supply
A
B
D
World
Price
P1
C
Domestic
Demand
Quantity
3. Refer to Figure 9-1. Consumer surplus in this market before trade is
a. A.
b. A + B.
c. A + B + C.
d. D.
e. A + B + D.
4. Refer to Figure 9-1. Consumer surplus in this market after trade is
a. A.
b. A + B.
c. A + B + C.
d. C.
e. A + B + D.
5. Refer to Figure 9-1. Producer surplus in this market before trade is
a. A.
b. A + B.
c. B + C + D.
d. C.
e. D.
6. Refer to Figure 9-1. Producer surplus in this market after trade is
a. A.
b. A + B.
c. B + C + D.
d. C.
e. D.
7. Refer to Figure 9-1. Total surplus in this market before trade is
a. A + B.
b. A + B + C.
c. A + B + C + D.
d. B + C + D.
e. A + B + D.
8. Refer to Figure 9-1. Total surplus in this market after trade is
a. A + B.
b. A + B + C.
c. A + B + C + D.
d. B + C + D.
e. A + B + D.
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Chapter 9 Application: International Trade
Figure 9-2
Price
92
28
26
24
22
20
18
16
14
12
10
8
6
4
2
Domestic
Supply
World Price
Domestic
Demand
200 400 600 800 1000 1200 1400
Quantity
9. Refer to Figure 9-2. Equilibrium price and equilibrium quantity without trade are
a. $18 and 400.
b. $18 and 800.
c. $14 and 400.
d. $14 and 600.
e. $14 and 800.
10. Refer to Figure 9-2. With trade, the domestic price and domestic quantity
demanded are
a. $18 and 400.
b. $18 and 600.
c. $18 and 800.
d. $14 and 400.
e. $14 and 600.
11. Refer to Figure 9-2. With trade, domestic production and domestic consumption,
respectively, are
a. 600 and 400.
b. 800 and 400.
c. 400 and 600.
d. 400 and 800.
e. 400 and 400.
12. Which of the following arguments for trade restrictions is often advanced?
a. Trade restrictions make all Americans better off.
b. Trade restrictions increase economic efficiency.
c. Trade restrictions are necessary for economic growth.
d. Trade restrictions are sometimes necessary for national security.
e. Trade restrictions increase total surplus.
Chapter 9 Application: International Trade
Free Response Questions
Price
1. Use the graph to answer the following questions about CDs.
$22
Domestic
Supply
15
World
Price
12
Domestic
Demand
2
35
a.
b.
c.
d.
e.
f.
g.
h.
i.
j.
k.
50
65
Quantity
What is the equilibrium price of CDs before trade?
What is the equilibrium quantity of CDs before trade?
What is the price of CDs after trade is allowed?
What is the quantity of CDs exported after trade is allowed?
What is the amount of consumer surplus before trade?
What is the amount of consumer surplus after trade?
What is the amount of producer surplus before trade?
What is the amount of producer surplus after trade?
What is the amount of total surplus before trade?
What is the amount of total surplus after trade?
What is the change in total surplus because of trade?
Price
2. Using the graph, answer the following questions about hammers.
Domestic
Supply
$22
14
World
Price
10
Domestic
Demand
5
50
a.
b.
c.
d.
e.
f.
90
135
Quantity
What is the equilibrium price of hammers before trade?
What is the equilibrium quantity of hammers before trade?
What is the price of hammers after trade is allowed?
What is the quantity of hammers imported after trade is allowed?
What is the amount of consumer surplus before trade?
What is the amount of consumer surplus after trade?
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Chapter 9 Application: International Trade
g.
h.
i.
j.
k.
What is the amount of producer surplus before trade?
What is the amount of producer surplus after trade?
What is the amount of total surplus before trade?
What is the amount of total surplus after trade?
What is the change in total surplus because of trade?
Chapter 9 Application: International Trade
Solutions
Multiple-Choice Questions
1. b TOP: Tariffs
2. a TOP: Exports / Economic Welfare
3. b TOP: Consumer surplus
4. a TOP: International trade / Consumer surplus
5. d TOP: Producer surplus
6. c TOP: International trade / Producer surplus
7. b TOP: Total surplus
8. c TOP: International trade / Total surplus
9. d TOP: Equilibrium price / Equilibrium quantity
10. c TOP: International trade / Equilibrium
11. b TOP: International trade / Equilibrium quantity
12. d TOP: Trade policy
Free Response Questions
1. a. $12
b. 50
c. $15
d. 30
e. $250
f. $122.50
g. $250
h. $422.50
i. $500
j. $545
k. $45
TOP: Exports / Economic welfare
2. a. $14
b. 90
c. $10
d. 85
e. $360
f. $810
g. $405
h. $125
i. $765
j. $935
k. $170
TOP: Imports / Economic welfare
95