Lessons from Chapter 3’s “farmer/rancher” example:
Specialization and trade (according to comparative
advantage) makes both parties better off.
Reason for economists’ general preference for free
trade and laws that promote free trade (NAFTA) . . .
(http://en.wikipedia.org/wiki/NAFTA)
. . . and their opposition to trade barriers, like
tariffs and quotas.
Not everyone agrees with this “free trade” philosophy.
One fairly recent case (www.pbs.org/newshour/ . . .)
In March 2002, President Bush imposed tariffs of up to
30% on imported steel in an effort to protect the
slumping American steel industry.
These tariffs were repealed in less than two years.
(http://www.cbsnews.com/ . . .)
More recently (Sept. 2009): President Obama imposed
tariffs on imports of tires from China.
(http://washingtonpost.com/ . . .)
Tariff is response to complaint filed with federal trade
panel by United Steelworkers union.
U.S. tire industry lost 5,000 jobs in 5 yrs. prior to 2010.
Four plants closed.
In favor of tariff: Workers and owners of U.S. tire
companies.
Opposed to tariff: Chinese tire companies, U.S. tire
importers, U.S. tire companies with plants abroad
Chinese Ministry of Commerce: “Tariff violates World
Trade Organization rules.”
World Trade Organization (http://www.wto.org/):
An international organization dealing with global rules of
trade among nations.
It’s “rules” are WTO agreements, negotiated and signed
by a large majority of the world’s trading nations.
Agreements are legal “ground rules” for international
commerce.
WTO serves as a “court” to mediate trade disputes.
Using supply and demand analysis with
consumer/producer surplus tools, we will address:
What determines the direction of trade flows?
(Why does a country import certain products
and export others?)
How are the gains from trade distributed?
(Not uniformly. Some gain; but some lose.
That’s why some in U.S. favor free trade in steel;
some oppose it.)
Simplifying assumptions of our analysis:
We’ll look at a hypothetical “small” country -- a
change in the country’s trade policy will have only a
negligible effect on the world market.
(Let’s call it “Isoland.”)
We’ll consider a homogeneous product -- “steel.”
Only one kind of steel. Domestic (Isolandian) and
foreign steel are exactly the same.
We’ll consider two markets:
- the “domestic” market (the market for steel in
Isoland)
- the “world” market (the market for steel in the
rest-of-the-world; i.e., other than Isoland)
Let’s start with a “no trade” case.
Isoland has strict laws prohibiting international trade
in steel.
One possibility:
($/ton)
($/ton)
Sd
Sw
pw
pd
Dw
Dd
(tons/yr.)
Isoland
(tons/yr.)
World
pd < pw is a reflection of the fact that Isoland has a
comparative advantage, relative to the rest-of-theworld, in steel production.
(Citizens of Isoland have to give up fewer units of
other goods to get a ton of steel than do citizens of
the rest of the world.)
(pd > pw would mean that the rest-of-the-world has a
comparative advantage relative to Isoland.)
Now consider the “free trade case.” (Imagine that
Isoland’s laws prohibiting trade are repealed.)
Isolandian steel producers won’t sell in Isoland at pd
when they can get pw on the world market.
Prices of steel in domestic and world markets will have
to equalize.
Because Isoland is a “small” country, domestic price
does all of the adjusting – increasing to the current
level of pw.
(Domestic consumers will have to pay pw in order to
buy any steel at all.)
($/ton)
Sd
price with
trade = pw
price before
trade
exports
domestic
quantity
demanded
Dd
domestic
quantity
supplied
(tons/yr.)
Now let’s consider the other possibility:
Before trade (when Isoland’s laws prohibit trade), the
domestic price, pd, might be above world price, pw.
pd > pw means the rest-of-the-world has comparative
advantage, relative to Isoland.
With free trade (when laws prohibiting trade are
repealed), Isolandian consumers won’t buy domestic
steel at pd when they can get foreign steel at pw.
Price of steel in Isoland will have to fall to pw.
(Domestic producers will have to sell at pw in order to
sell any steel at all.)
($/ton)
Sd
price before
trade
price with
trade = pw
imports
domestic
quantity
supplied
domestic
quantity
demanded
Dd
(tons/yr.)
What determines the direction of trade flows?
When pd < pw (Isoland has comparative advantage in
steel), Isoland will export.
When pd > pw (Rest-of-the-world has comparative
advantage in steel), Isoland will import.
Consistent with lessons from “farmer/rancher” example.
Now let’s use consumer/producer surplus to illustrate
gains from trade and see how they’re distributed.
Consider the exporting country first.
($/ton)
price with
trade = pw
price before
trade
Sd
A
B
quantity
consumed
domestically
quantity
produced
domestically
D
C
Dd
(tons/yr.)
consumer surplus
producer surplus
total surplus
before trade
A+B
C
A+B+C
with trade
change
A
-B
B + C + D + (B + D)
A+B+C+D
+D
Now let’s look at the case of an importing country.
($/ton)
Sd
A
price before
trade
price with
trade = pw
B
quantity
consumed
domestically
D
C
quantity
produced
domestically
Dd
(tons/yr.)
consumer surplus
producer surplus
total surplus
before trade
A
B+C
A+B+C
with trade
change
A + B + D + (B + D)
C
-B
A+B+C+D
+D
Recap:
Regardless of whether the country ends up as an
exporter or an importer . . .
. . . there are net gains from trade.
Gains are not uniformly distributed, however.
Some gain,
. . . some lose,
. . . but gainers’ gains outweigh losers’ losses.
Those who stand to lose from free trade have an
incentive to argue for trade barriers.
Tariff: A tax on goods produced abroad and sold
domestically.
(. . . like President Obama’s tariff on
imports of tires).
Quota: A limit on the quantity of foreign-produced
goods that can be sold domestically.
Effects of a tariff
. . . on “steel,” let’s say.
For this analysis,
- keep “small” country assumption -- Isoland
- keep homogeneous good assumption.
- take “free trade” as the starting point.
- assume that Isoland is an importer of steel to start.
(pw < pd, the domestic price that would prevail if
trade were prohibited)
- then government of Isoland imposes a tariff (tax on
imported steel) of t $/ton.
The tariff will raise the price to Isolandian consumers of
foreign-made (imported) steel by t $/ton.
(Wait a minute! In chapter 6 we said that tax burden is
shared. Buyers’ price goes up by less than $t/ton?
. . . unless supply is perfectly elastic.)
Because steel is a homogeneous good, the price of
domestically produced steel will also rise by t $/ton.
(Domestic producers can raise their price when the
price of imported steel goes up.)
The market for steel in Isoland:
($/ton)
Sd
pw
imports
Q1s
Before the
tariff goes
into effect . . .
Dd
Q1d
price (of foreign and domestic steel) = pw $/ton.
quantity demanded domestically = Q1d tons/yr.
quantity produced domestically = Q1s tons/yr.
quantity imported = Q1d - Q1s tons/yr.
(tons/yr.)
The market for steel in Isoland:
($/ton)
The tariff
raises the price
of steel by
t $/ton.
Sd
pw + t
pw
imports
Q1s Q2s
Q2d
Dd
(tons/yr.)
Q1d
price (of foreign and domestic steel) = pw + t $/ton.
quantity demanded domestically = Q2d tons/yr.
quantity produced domestically = Q2s tons/yr.
quantity imported = Q2d - Q2s tons/yr.
Now the
welfare analysis:
($/ton)
Sd
D
B
A
The tariff results
in a deadweight
loss of D + F.
pw + t
pw
F
C
E
Dd
G
Q1s Q2s
w/o tariff
consumer surplus A+B+C+D+E+F
producer surplus
G
tariff revenue
0
total surplus
A+B+C+D+E+F+G
Q2d
w. tariff
A+B
C+G
E
A+B+C+E+G
Q1d (tons/yr.)
change
- (C+D+E+F)
+C
+E
- (D+F)
Let’s take a closer look at the deadweight loss.
($/ton)
D is a loss due to
“over-production”:
Domestic producers
supply Q2s - Q1s tons/yr.
that could be produced
at lower opportunity
cost abroad.
Sd
D
F
pw + t
pw
Dd
Q1s Q2s
Q2d
Q1d (tons/yr.)
F is a loss due to “under-consumption”: Q1d - Q2d tons/yr.
are not consumed, even though willingness to pay exceeds
(foreign) opportunity cost of production.
Let’s review the tariff’s effects.
When the tariff is imposed:
Domestic (Isolandian) producers gain -- they sell more
at a higher price. (That’s the point. Tariffs are
supposed to help domestic producers.)
Domestic (Isolandian) consumers lose -- they consume
less at a higher price.
Some of domestic consumers’ loss . . .
. . . is recaptured by domestic producers (area C),
. . . some shows up as tariff revenue (area E),
. . . but some is not recaptured; it’s the deadweight
loss (areas D and F).
For the economy as a whole (considering just the
maximization of total surplus), the tariff is bad policy.
What about a quota?
Suppose that, instead of a tariff = t $/ton, the
government limited steel imports to Q2d - Q2s tons/yr.
A little more complicated, but here’s the bottom line:
Effects very similar to that of the tariff.
In particular . . .
. . . same effect on price (increase to pw + t $/ton),
. . . same effects on quantities produced and
consumed domestically, and
. . . same effects on consumer and producer surplus.
The only difference:
What happens to the tariff revenue (area E)?
Government would achieve import restriction by issuing
licenses to import Q2d - Q2s tons/yr. -- no more.
Holders of these licenses could buy foreign steel at pw
on world market and resell it at pw + t in Isoland.
What was tariff revenue becomes profit for import
license holders . . .
. . . unless, of course, government charges a
price for the licenses.
Now back to the tariff. The lesson is that tariffs are bad
policy.
So why do we have tariffs?
Shouldn’t our nation’s leaders recognize that tariffs are
bad policy and just say “No!”?
A couple of possibilities:
Maybe there are some good reasons for tariffs (or other
kinds of trade barriers) -- more on this later.
Or, maybe those who stand to gain from the tariff
(workers and owners of domestic firms) have more
political clout than those who stand to lose (domestic
consumers).
Total gains/losses vs. per capita gains/losses and
incentives to lobby.
An example using some hypothetical numbers:
Loss from tire tariff in U.S. = higher prices for
consumers of tires:
$2/person/year x 300,000,000 people in U.S. =
total loss of $600,000,000/year
Gains from tire tariff in U.S. = greater job security for
tire industry workers (valued at $10K/worker/year):
$10,000/worker/year x
30,000 workers in U.S. tire industry =
total gain of $300,000,000/year.
Total loss is twice as great as total gain.
But per capita loss ($2/loser) is trivial compared to per
capita gain ($10,000/gainer).
Potential gainers have much more incentive to lobby
than potential losers.
Arguments (some valid; some bogus) for trade barriers:
“Jobs” argument:
Permitting imports will reduce domestic production of
the good and reduce employment in the domestic
industry.
“National security” argument:
For certain products, production capacity must be
maintained because it is vital in times of crisis.
“Infant-industry” argument:
Sometimes new industries need temporary protection
from import competition to help them get started.
“Protection-as-a-bargaining-chip-or-weapon” argument:
The only way to convince our trading partners to
drop their trade barriers may be to threaten them
with trade barriers of our own.
“Unfair competition” argument
Foreign governments sometimes subsidize their
export industries. U.S. industries only want a “level
playing field.”
(This was probably the main argument used to
support the Bush administration steel tariffs.)
Now back to President Obama’s tire tariff . . .
Some argue that:
China is guilty of “predatory trade practices.”
Our tire tariff may be bad policy, but it sends the
right message.
For a defense of Obama tire tariff (using “Protection as
a weapon” argument) see:
http://www.washingtonpost.com/ . . .
One risk of imposing trade barriers:
Trigger “tit-for-tat” retaliation and a “trade war.”
Just this past September:
China imposed a steep tariff on U.S. poultry
(http://www.nytimes.com . . . )
Poultry is one of the few categories in which the U.S.
runs a trade surplus with China.