Topic 3B: Extremely Competitive Open Markets
LECTURE NOTES
International trade (the exchange of goods and services between countries) is rooted in
microeconomics because it involves the demand, production and sale of goods and
services in specific industries in which the exporting/importing countries may have a
distinct advantage or disadvantage but it also has macroeconomic implications because it
can affect a country’s level of employment, inflation, exchange rate and other
macroeconomic variables.
The idea behind international trade is the same as the idea behind trade in a closed
economy: you’re better at baking bread than I am so I buy bread from you. I’m better at
fixing appliances than you are so you pay me to fix your refrigerator. There are
advantages to both of us from this type of exchange. In a closed economy the bread and
refrigerators as well as the services related to them are manufactured and provided
exclusively within the country. International trade involves opening up this type of
exchange across countries.
The Determinants of Trade
The costs and benefits from trade are analyzed by comparing the market outcomes with
and without trade, including the market-clearing price and quantity, on domestic and
foreign consumers, producers and governments. This type of analysis helps us identify
who are the winners and losers from increased trade or restrictions to trade.
Understanding these underpinnings of international trade is extremely important for firms
pursuing business strategies in competitive world markets
Power Point Presentation “International Trade”
In a strict economic sense, trade makes both exporting and importing countries better off
in that overall welfare (consumer + producer surplus) increases. It may also have
additional benefits in that it may contribute to increased economies of scale, competition,
efficiency and exchange of technologies and ideas.
But, in the case of exporting countries (world price > domestic price) consumers are
worse off and producers are better off whereas in the case of importing countries (world
price < domestic price), consumers are better off and producers are worse off. The total
economic well-being of the nation is improved because the gains of the winners exceed
the losses of the losers. But, because there are losers there is discontent associated with
trade resulting in trade restrictions, disagreements and controversies.
Question: From where does the main opposition to trade tend to emanate?
Answer: When the world price < domestic price  imports increase and producers are
worse off (although consumers are better off). Even though the overall losses to
producers are less than the gains to consumers, producers tend to be more concentrated,
more knowledgeable and better organized than consumers and therefore to have a
stronger say in opposing free trade when this results in losses to them. Therefore, they
have a strong incentive to lobby for trade restrictions.
Trade Restrictions:
Tariffs
Quotas
Subsidies
Other Trade Barriers: health or environmental-related regulations, regulations pertaining
to quality, packaging, delivery requirements, etc.
Overall arguments for trade restrictions:
 Protect domestic producers/jobs from competition
 National security
 Infant Industry
 Unfair competition
 Protection as a bargaining chip
 Macroeconomic stability
 Environmental/health and human rights considerations
1. Protection of domestic producers/jobs: Per se, this argument does not have much
popularity among economists. A country should concentrate on those sectors in
which it has a comparative advantage. This will result in a better use of the country’s
resources and lower prices and more variety for consumers. If the US is really not as
efficient at producing steel or textiles as Korea or China but is a lot more efficient at
producing telecom infrastucture and television programs then it should produce less
of the former and more of the latter. Nonetheless, this is one of the strongest
arguments made for protectionist policies. If French residents do not buy foreign
goods they will spend the money at home, creating more jobs for French residents.
Again, an economist’s response to this argument is that in the end it protects no one
and may end up instead reducing the overall standard of living of the country as well
as of other countries. Opposing trade so as to protect domestic jobs can lead to what
are known as beggar-they-neighbor policies in that the jobs gained in one country
are at the expense of jobs in another country. But in fact, this policy often ends up
reducing jobs even in the country implementing the policy. If the French impose very
high tariffs on imports so that French consumers purchase French products for the
most part, this may protect French jobs (compared to the alternative) for a while but it
will also have two other negative effects: (1) the prices of those products may be
significantly higher than in the absence of protectionism (which harms French
consumers); and (2) there will fewer exports of products from France to other
countries both because the other countries may retaliate and because France has not
concentrated on producing products in which it has a comparative advantage. The
result will be a reduction of French income and jobs from exports. Economists
believe that one of the worst cases of this type of policy occurred during the Great
Depression, when the US passed the Hawley-Smoot Tariff Act raising tariffs on
many products to levels which made imports unattractive. Imports to the US
declined. This led to declines in incomes in other countries that used to export to the
US. They in turn purchased fewer goods from the US and themselves imposed
retaliatory tariffs. This resulted in declines in US exports and incomes and so forth.
The result contributed, experts believe, to making the Depression particularly severe
and deep and had a “contagion” effect which affected many different countries
worldwide.
Of course, it is important to realize that allowing the importing of goods and services
from more efficient producers outside the country will result in a loss of revenue for
some sectors. This may involve significant hardship for those industries. The
government may then decide to ease these hardships e.g. by providing training to
displaced workers, low interest loans, tax credits to
On the other hand, the loss of jobs (or reduction in wages to be more competitive with
cheaper imports) is a real hardship. Rather than protecting those jobs by imposing
trade restrictions, the government could ease the effect on the labor market by passing
laws that offer special assistance and training to displaced workers, low interest loans,
special extended unemployment insurance provisions, tax credits to industry to shift
production to an sector of greater comparative advantage, etc. Of course, how well
and quickly this works depends on many factors, including the unemployment rate in
the country, the age of the workers, the mobility of the workers, and even the
efficiency of capital markets, etc. Unfortunately, trade liberalization often affects
workers that do not have otherwise marketable skills outside their industry or are
already among the poorest in the country. For example: US textile workers or Central
American coffee farmers. Thus, the hardship can be extreme. Economists can
comment only on the benefits of trade liberalization overall and over time, i.e. that
the increase in surplus to the winners is greater than the decrease in surplus to the
losers. This ignores the distributional effects (between winners and losers) and other
repercussions not acknowledged in the standard economic analysis. For example, in
countries with high rates of unemployment, international trade which results in job
losses (opening country up to cheap imports, lifting tariffs and quotas or subsidies)
does not result in an eventual shift of workers from the displaced sector to another
sector but, more likely, to prolonged unemployment. The result then of trade
liberalization may be more serious macroeconomic effects, such as increases in the
poverty rate, infant mortality rate and declines in life expectancy (See Stiglitz,
Globalization and Its Discontent, chapters 3, 5). In this case, there may really be no
way for the winners to compensate the losers, even over time (unless you go to the
next generation.)
2. National security: Some sectors are too sensitive for defense/national security
reasons to be opened up to trade.
3. Infant Industry Protection: The rationale here is that new industries (or industries
that are not necessarily new worldwide but are new in a given country) need
temporary protection from worldwide competition in order to grow. As Mankiw
points out, economists generally are skeptical about the logic of such arguments in
that they essentially protect less efficient industries (on a worldwide scale of
efficiency). If those industries indeed showed the potential for new breakthroughs,
new products, lower costs etc., then they should be able to attract capital without
protection. But that argument ignores a number of countervailing factors: (1) certain
industries may not have adequate access to capital markets for a number of reasons,
ranging from nepotism and corruption in the banking industry to risk aversion and
lack of transparency in domestic financial markets; (2) certain countries may believe
that it is in their best long-term interest for its labor force to invest in some “learningby-doing” so that the labor force becomes more knowledgeable and less reliant on
foreign know-how (e.g. software in Mexico.)
4. Unfair competition/fair trade whereby the government of a trading country
subsidizes some industry or product in that country-- for example, by giving it
significant tax breaks. The domestic (nonsubsidized) producers of the product might
argue that they should be protected against this “unfair” competition.” This is a very
serious trade issue and one that is the focus of both the WTO’s mandate to uphold
international trade law as well as standards and conditions imposed by the EU to its
member countries. For example, the EU recently ruled that Spanish subsidies to the
shipbuilding industry had not only to be eliminated but in large portion reimbursed to
the Spanish government over a number of years. In the US, Boeing has for years
vehemently complained about “unfair subsidies” granted to its competitor Airbus
from the UK and French governments. (On the other hand, Boeing may itself
receive some form of subsidy from the US government in the form of defense
contracts.) To ensure fair competition, economists argue that the same laws that
apply domestically should apply internationally between trading partners. Another
law that is often resorted to in the name of “fair trade” is the anti-dumping law.
Dumping refers to the sale of products to another country at a price below the
producing country’s cost of production (predatory). If a country is found guilty of
dumping, a tariff will be imposed on the price of its goods equal to the difference
between the export price and the cost of production. However, according to Stiglitz
(Principles of Economics, p. 368), the antidumping laws are most often used (abused)
as a protectionist rather than fair trade tool. The standard for measuring the cost of
production is based on what it would cost to produce the good in a “comparable or
surrogate country”. Often the way this is calculated is ridiculous or erroneous. See
example of aluminum in Russia (Globalization and Its Discontent, p. 173).
5. Protection as a Bargaining Chip Argument whereby the threat of a trade restriction
by one trading country can help remove a trade restriction imposed by another
country. (It also may be used in bargaining with regard to non trade issues, such as
human rights.) The WTO is now playing a big part in this type of bargaining. If a
country is found to have improperly imposed trade restrictions against another
member of the WTO, the latter can retaliate by itself imposing sanctions or other
restrictions. Examples:
 In 2001, in response to US banana producers (Dole and Chiquita) complaints of
European countries’ policy of favoring purchases of bananas from ex European
colonies, the WTO found the EU was in violation of GATT and allowed the US to
retaliate in the form of 100% tariffs imposed on many luxury goods imported from
Europe (luxury leather goods and linens and specialty foods, i.e. Gucci bags, Hermes
scarves and Roquefort cheese.) The EU conceded defeat and changed its policy and
the US lifted the tariffs.
 In August of 2003, the WTO ruled that US tariffs on imported steel were illegal and
allowed the EU to impose more than $2 billion in retaliatory tariffs on key US

exports, including citrus fruits and juices, agricultural equipment and paper products.
By the end of the year, the US lifted its steel tariffs.
In 2002, the WTO ruled that the EU could impose $4 billion in penalties on the US
because of tax breaks given to US companies that operate overseas, arguing that these
amount to illegal export subsidies.
6. Macroeconomic Stability and Volatility
Liberalization of trade can bring significant volatility to output, prices, jobs, etc. In
particular, according to some economists, liberalization of financial services can have a
destabilizing effect on macroeconomic stability. Complete liberalization of financial
services results in the ability of “hot” money to flow very quickly in and out of a country.
As it provides increased liquidity and access to capital when things are good, the opposite
is true when things are bad. Furthermore, large foreign banks may be less interested in
lending to a country’s local businesses, preferring to lend to large multinational
corporations. They will also be less susceptible to government pressure to lend during an
economic downturn or to contract lending when the economy is overheated. “In
developing countries, this ‘guidance’ from the government may be an important tool for
macroeconomic stability” (Stiglitz, Principles, p. 375). For example, China’s
government has been liberalizing capital markets very gradually, with capital controls
still in place in certain sectors. This policy of capital controls ensured that capital did not
swiftly flow out of China during the Sars epidemic scare. Economies with more
developed capital markets are better able to hedge against volatility resulting from trade
liberalization. There are important differences in the ability to manage risk between
developed and developing countries and, therefore, that there is an asymmetry in the
effects of liberalizing trade in developed versus developing countries. However, given
the current serious crisis in financial markets of developed countries, we may need to
question the ability of developed market economies to deal with financial market
liberalization and, generally, with the effects of globalization. Class discussion.
7. Environmental, Health and Human Rights Considerations
There are environmental and health considerations associated with international trade
which are not specifically elements of the trade itself but rather of underlying rules and
regulations specific to the countries engaging in trade. Thus, a country may decide not to
import goods and services which it believes do not meet its own health, environmental
standards or rather to require that all imports all meet those standards. Examples include:
food products with growth hormones, Genetically Modified Foods (GMOs), inadequate
labeling of contents, unsanitary packaging facilities, excessive pollution emissions. Also,
some countries may decide not to trade with other countries where working conditions
are significantly inadequate (child labor, excessive hours, extremely low pay, unsanitary
working conditions) or human rights violations are a serious concern.
READINGS
1. How to Fight Currency Wars with a Stubborn China, Financial Times,October 6, 2010.
http://www.biblio.liuc.it:2248/lnacui2api/api/version1/getDocCui?lni=515R-RT81-JBFSD154&csi=293847&hl=t&hv=t&hnsd=f&hns=t&hgn=t&oc=00240&perma=true
2. Free of Quota, China Textiles Flood the US, The New York Times, March 10, 2005.
http://www.biblio.liuc.it:2248/lnacui2api/api/version1/getDocCui?lni=4FNM-CWS0TW8F-G2RY&csi=6742&hl=t&hv=t&hnsd=f&hns=t&hgn=t&oc=00240&perma=true
3. Battle is Looming Over Cotton Subsidies, The New York Times, January 24, 2004.
http://www.biblio.liuc.it:2248/lnacui2api/api/version1/getDocCui?lni=4BHY-HMR001KN-23D5&csi=6742&hl=t&hv=t&hnsd=f&hns=t&hgn=t&oc=00240&perma=true
4. Sugar Subsidy Reform: A Bittersweet Story, Emerging Markets Monitor, July 4, 2005,
Vol. 11, Issue 13, p. 21. NEW LINK—click on PDF Full Text
http://www.biblio.liuc.it:2262/login.aspx?direct=true&db=bth&AN=17526802&site=eho
st-live
5. U.S. Loses Appeal on Steel Tariffs; WTO Decision Lets EU Retaliate, Washington
Post, Nov. 11, 2003.
http://www.biblio.liuc.it:2248/lnacui2api/api/version1/getDocCui?lni=4B06-M790TW87-N2KB&csi=237924&hl=t&hv=t&hnsd=f&hns=t&hgn=t&oc=00240&perma=true
6. U.S. Slaps Sanctions on EU in Banana War’s First Strike; Clearance Withheld on
Imports from France, Italy and Britain, The Globe and Mail, March 4, 1999.
http://www.biblio.liuc.it:2248/lnacui2api/api/version1/getDocCui?lni=4M8C-DTJ0TW7J-32M4&csi=237924&hl=t&hv=t&hnsd=f&hns=t&hgn=t&oc=00240&perma=true
7. The Airbus-Boeing Dispute: Implications of the WTO Boeing Decision,
Intereconomics,Vol. 45, Issue 5, September 2010.NEW LINK—click on PDF Full Text
http://www.biblio.liuc.it:2262/login.aspx?direct=true&db=bth&AN=54371982&site=eho
st-live
8. “Why the Oil Price is Falling,” The Economist, December 8, 2014.
http://www.economist.com/blogs/economist-explains/2014/12/economist-explains-4
SAMPLE PROBLEMS
1. International Trade: Tariffs versus Quotas
In the late 1970s, the US government agreed to allow importing of fuel efficient compact
cars into the US. In doing so, it considered the following two proposals:
(1) Allow imports of Japanese cars into the US but subject to a 20% tariff.
(2) Allow a limited quota of Japanese cars to be imported. The quota amounts would be
allocated in equal amounts to Toyota and Honda with no license fees.
For simplicity, assume the impact of the quota on price is equivalent to the tariff, i.e., it
results in a US price for the Japanese cars with the quota equal to the unrestricted world
price + 20% tariff.
a. If you were the chief operating officer of Toyota, which of these two trade proposals
would you prefer and why?
b. If you were an economic adviser to the US president, which of these two trade
proposals would you prefer and why?
Answer:
a. I would prefer the quota proposal for two reasons:
(1) The quotas would be granted exclusively to Toyota and one other competitor, Honda.
Under the tariff system, any producer of fuel efficient cars could export them into the US
and therefore, Toyota would face a lot more competition for its sales.
(2) Under both the quota system with no license fees as under the tariff, the domestic
(US) price of the imported cars will be higher than the world price, as shown in the graph
below. However, under the quota system with no license fees, this results in profits for
holders of the import licenses. The profit derives from being able to sell the cars at the
higher US domestic price associated with the imposition of the quota (Pq) compared to
the lower world price Pw. It is equal to the area (Pq – Pw) * (Qd(Pq) – Qs(Pq)). Since
we are assuming that Pw + t = Pq, this same area is revenue to the US government under
the tariff system. See graph below.
$/car
Domestic supply
Domestic supply + quota
Pw+t= Pq
Pw
Domestic demand
Qs(Pw) Qs(Pq) Qd(Pd)
Qd(Pw)
Fuel efficient compact
cars/month
b. I would prefer the tariff proposal for many of the same reasons that Toyota and Honda
would prefer the quota system. Specifically:
(1) The quota system results in less competition in the market for fuel efficient cars
exported into the US.
(2) It also incentivizes a system of lobbying by Japanese car companies to the US
government to be granted the import license quota.
(3) Finally, without a charge for the license fee, it results in no revenue for the US
government (and its taxpayers) compared to the tariff. Under a tariff system, the area of
profit to the license holders is tariff revenue to the US government.
Some students may suggest that the government may prefer the quota because it gives it
some negotiating leverage with Japan (bargaining chip) on this and other matters.
2. Arguments for Restricting Trade
Explain how the “jobs protection argument” for restricting trade leads to hypocritical
positions on trade.
Answer: The jobs argument would lead countries whose domestic equilibrium price in
certain industries is lower than the world price (i.e. exporters) to be in favor of free trade
so as to promote domestic jobs in those industries. The opposite would occur in the case
of countries whose domestic equilibrium price in certain industries was higher than the
world price (i.e. importers). They would oppose free trade and promote restrictions on
trade in those industries in order to protect domestic jobs in those industries. Note that
the same country can therefore take positions for and against trade restrictions across
different industries. For example, the US is a strong proponent of free unrestricted trade
in financial and telecommunications services but imposes significant trade restrictions
(import tariffs, quotas and domestic subsidies) in textiles and certain agricultural crops.
3. Production Subsidies
Suppose the domestic demand and domestic supply for wheat in Algeria is characterized
by the following functions.
Qd = 1500 – 5P
Qs = -1100 + 5P
Where P is in Algerian dinars and Q is in thousands of bushels per year.
Algeria is a small economy relative to the world demand and supply of wheat.
a. Find the market equilibrium price and quantity for wheat in Algeria under autarky (no
trade). Show these on a graph. Calculate producer revenues and consumer expenditures.
b. Suppose the world price for wheat is 240 dinars/bushel. If Algeria opens up to
trade, will it be a net importer or exporter of wheat? What will be the prevailing price of
wheat in Algeria? How much will Algeria produce domestically and how much will it
import/export? Show this outcome graphically. Calculate the effect on domestic
producer revenues and consumer expenditures from Algeria’s opening itself up to
international trade in the market for wheat?
Algerian wheat farmers are outraged at their loss in revenue due to the lower world price.
They lobby the Algerian government for intervention on their behalf. The Algerian
government elects to give farmers a production subsidy of 10 dinars/bushel.
c. What price will consumers face and how much will they consume under the subsidy?
How many bushels of wheat will Algerian farmers produce? How many bushels will be
imported? Show this outcome graphically (in a separate graph or on the one you
provided in (b) above.) Calculate producer revenues and consumer expenditures. How
much will these subsidies cost the Algerian government?
Answer:
a. Qd = Qs
1500 – 5P = -1100 + 5P
2600 = 10P
P* = 260 dinars/bushel
Qd = 1500 – 5(260) = 200
Q* = 200 thousand bushels/year
Producer revenues = 260*200,000 = 52,000,000 dinars/year
Consumer expenditures = 260*200,000 = 52,000,000 dinars/year
Dinars/
bushel
300
P*=260
Pw=240
220
Thousands bushels/year
100
200
300
Imports
1500
b. Algeria will be a net importer of wheat. The prevailing price will be the world price,
240 dinars/bushel.
Qs= -1100 + 5(240) = 100 thousand = 100,000 bushels/year
Qd = 1500 – 5(240) = 300 thousand = 300,000 bushels/year
Imports = 300 – 100 = 200 thousand = 200,000 bushels/year
Producer revenues = 240 * 100,000= 24,000,000 dinars/year
Consumer expenditures = 240 * 300,000 = 72,000,000 dinars/year
c. Consumers will still pay 240 dinars per bushel, as before. The imposition of the
production subsidy does not affect the world price paid by consumers. Thus, the quantity
they consume (300,000 bushels/year) also remains unchanged.
With the production subsidy producers receive world price + subsidy, i.e. 240 + 10 = 250
Thus, producers will supply:
Qs = -1100 + 5(250) = 150 thousand = 150,000 bushels/year
Qd = same as before = 300 thousand = 300,000 bushels/year
Imports = Qd – Qs = 300 – 150 = 150 thousand = 150,000 bushels/year
Producer revenues = 250 * 150,000 = 37,500,000 dinars/year
Consumer expenditures = same as before = 72,000,000 dinars/year
Cost to government = 10 * 150,000 = 1,500,000 dinars/year
Dinars/
bushel
300
P*=260
Ps=250
Pw=240
220
Thousands bushels/year
100 150 200
300
Imports
1500