TRADING WITH
THE WORLD
17
CHAPTER
Objectives
After studying this chapter, you will able to
ƒ Describe the trends and patterns in international trade
ƒ Explain comparative advantage and explain why all
countries can gain from international trade
ƒ Explain why international trade restrictions reduce the
volume of imports and exports and reduce our
consumption possibilities
ƒ Explain the arguments that are used to justify
international trade restrictions and show how they are
flawed
ƒ 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 allowed—Marco Polo’s silk route between
Europe and China is an example.
Many people fear free trade and some predicted a “giant
sucking sound” as jobs left the United States for Mexico
under the NAFTA.
Why do we trade with other nations?
Do tariffs that restrict trade bring any benefits?
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. imports
and 68 percent of exports.
Raw materials and semi-manufactured materials represent
14 percent of U.S. exports and 15 percent of imports.
The largest export item from the United States is capital
goods and the largest import item is automobiles.
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
U.S. exports and 17 percent of U.S. imports.
Japan is our second largest trading partner with 8 percent
of our exports and 9 percent of our imports.
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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
American spent on goods and services.
In 2003, the United States exported 10 percent of its total
output and imported 15 percent of the total amount that
American spent on goods and services.
Patterns and Trends in International
Trade
Net Exports and International Borrowing
The value of exports minus imports is called net exports.
In 2003, imports exceeded exports in the United States, so
net exports were negative $500 billion.
When a country imports more than it exports, it must
borrow from foreigners or sell some of its assets.
When a country exports more than it imports, it must make
loans 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.
The Gains from International Trade
Opportunity Cost in
Farmland
Figure 33.1 shows the
production possibilities
frontier for an imaginary
country called Farmland.
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The Gains from International Trade
Without international trade,
Farmland produces and
consumes 15 billion
bushels of grain and 8
million cars at point A.
The opportunity cost of a
car is 9,000 bushels of
grain.
The Gains from International Trade
Opportunity Cost in
Mobilia
Figure 33.2 shows the
production possibilities
frontier for another
imaginary country called
Mobilia.
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The Gains from International Trade
Without international trade,
Mobilia produces and
consumes 18 billion
bushels of grain and 4
million cars at point A'.
The opportunity cost of a
car is 1,000 bushels of
grain.
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 car—a
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 grain—a
much lower price than the opportunity cost of producing
cars in Farmland.
The Gains from International Trade
The Terms of Trade
The quantity of grain that
Farmland must pay Mobilia
for a car is called
Farmland’s terms of trade
with Mobilia.
Figure 33.3 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.
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.
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 (four 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
imports—4 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 lower price than it would pay if it
made them itself, and sells its grain at a higher price.
Mobilia buys grain at a lower price than it would pay if it
grew the grain itself, and sells its cars at a higher price.
Everyone gains from trade.
The production possibilities frontier illustrates the
production possibilities of a country, but it does not show
the consumption possibilities of a country that engages in
international trade.
The Gains from International Trade
Figure 33.4 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
by decreasing car production and increasing grain
production until its own opportunity cost of producing cars
equals that of the world terms of trade and exchanging
grain for cars at those terms of trade.
Mobilia increases its consumption of both cars and grain by
increasing car production and decreasing grain production
until its own opportunity cost of producing cars equals that
of the world terms of trade and exchanging cars for grain at
those terms of trade.
The Gains from International Trade
Gains for All
Both countries gain by consuming output combinations
outside their respective production possibilities frontier.
Trade does not create winners and losers.
It creates only winners.
Farmers selling grain and Mobilians selling cars face
increased demand and higher prices.
Farmers buying cars and Mobilians buying grain face
increased supply and lower prices.
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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 VCRs from Korea,
machinery from Europe, and fashion goods from Hong
Kong and in exchange for machinery, grain, lumber,
airplanes, computers, and financial services.
Everyone gains 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.
International Trade Restrictions
Governments restrict international trade to protect
domestic producers from competition by using two main
tools
ƒ Tariffs
ƒ 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
Tariffs
Figure 33.5 shows
how the average
tariff rate has
generally fallen
over the last 70
years.
Average tariffs
reached their peak
of 20 percent in
1933.
International Trade Restrictions
The 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.
The United States joined GATT in 1947.
Subsequent rounds of the GATT occurred in the 1960s,
late 1970s and 1980s, resulting in gradual decline in the
average tariff rate in the United States
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International Trade Restrictions
The Uruguay round was the most ambitious and lead to
the creation of the World Trade Organization (WTO).
The United States became a WTO member in 1994.
WTO membership brings greater obligations to follow the
GATT rules governing trade.
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 being lowered.
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 33.6 uses the
Farmland and Mobilia
example to illustrate the
effects of a tariff on car
imports into Farmland.
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, and the
government collects the
tariff revenue.
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International Trade Restrictions
The supply curve shifts leftward and the vertical distance
between the free-trade supply curve and the new supply
curve equals the amount of the tariff.
The price of a car in Farmland rises.
The quantity of cars imported by Farmland decreases.
The Farmland government collects tariff revenue.
Resources use is inefficient.
The value of exports changes by the same amount as the
value of imports and trade remains balanced.
International Trade Restrictions
Nontariff Barriers
There are two main types of non-tariff barriers to trade.
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 33.7 uses the
Farmland and Mobilia
example to illustrate the
effects of a quota on
automobiles imported into
Farmland.
International Trade Restrictions
The quota limits the
quantity that may be
imported.
At the quota quantity,
buyers are willing to pay
more than the price that
sellers are willing to
accept.
Importers profit by buying
at a lower price than the
price at which they sell.
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International Trade Restrictions
A quota can generate the
same price, quantity, and
inefficiency as a tariff but
with a quota, the importer
makes an economic profit
equal to what the
government receives as
tariff revenue with a tariff.
A VER is similar to a quota
except that the exporter
captures the economic
profit.
The Case Against Protection
Despite the fact that free trade promotes prosperity for all,
trade is restricted.
It is often argued that international trade should be
restricted to
ƒ Protect national security
ƒ Protect infant industries
ƒ Punish dumping
None of these arguments bear scrutiny.
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The Case Against Protection
Other fatally flawed arguments for protection are that it
ƒ Saves jobs
ƒ Allows us to compete with cheap foreign labor
ƒ Brings diversity and stability to our economy
ƒ Penalizes nations with lax environmental standards
ƒ Protects national culture
ƒ Prevents rich nations from exploiting poor ones
The Case Against Protection
The National Security Argument
The national security argument is that a country must
protect domestic industries that make defense equipment
and armaments, and those industries that provide the raw
material necessary for defense production.
The argument is flawed for two reasons: (1) In time of war,
there is no industry that does not contribute to national
defense, so it is a plea for economic isolation. (2) It is less
inefficient to subsidize defense than to restrict trade with a
tariff.
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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-bydoing.
The Case Against Protection
Learning-by-doing is a powerful engine of productivity
growth, but this fact does not justify protection.
Government action is needed to encourage learning-bydoing only when its benefits spill over to other parts of the
economy.
And even in this case, it is more efficient to subsidize an
infant industry than to protect it by restricting trade.
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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 is flawed because:
It is virtually impossible to determine a firm’s costs;
If there was a natural global monopoly, it would be more
efficient to regulate it than to impose a tariff against it.
The Case Against Protection
Saves Jobs
The idea that buying foreign goods costs domestic jobs is
wrong.
It destroys some jobs and creates other better jobs.
It 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.
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.
The Case Against Protection
Protects National Culture
The idea that trade restrictions protect the national culture
is wrong.
This argument is not heard in the United States as much
as it 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.
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The Case Against Protection
Protecting “cultural” industries is a form of rent seeking,
using cultural identity to eliminate competition from other
culturally related goods and services.
The surest way to eliminate a culture is to impoverish a
nation.
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.
Why Is International Trade Restricted?
The two key reasons why international trade is restricted
are
ƒ Tariff revenue
ƒ 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.
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.
For example, under NAFTA, a $56 million fund was
created to support and retrain workers who lot their jobs
from foreign competition resulting from the agreement.
THE END
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