Trade Policy
10
Opposition to Free Trade
• In 1999, 40,000 activists gathered in Seattle,
during a WTO ministerial meeting, condemning
all further actions to liberalize world trade.
• Resistance to free trade is not only in the US, but
it is evident worldwide
The Protectionist Viewpoint
• Protectionists are against free trade and believe
that barriers to trade are needed to promote the
welfare of a country
The Protectionist Viewpoint
• Some protectionist arguments:
▫ The shrinking size of the US market for goods that
compete with foreign goods reduces demand for
domestic labor
▫ Rising imports contributes to a trade deficit
▫ Vital/strategic industries need protection, e.g.,
weapons and nuclear energy
The Protectionist Viewpoint
• Some protectionist arguments:
▫ Free trade leads to environmental degradation
and exploitation of the impoverished people of
under developed countries
The Free Trade Viewpoint
• The free trade advocates argue that people are
better off when voluntary exchange is allowed
• Trade between nations is beneficial as trade
between individuals within a country
Questions:
• Who benefits from trade? Who does trade harm?
Do the gains outweigh the losses?
• Who are the losers and winners from restricting
trade?
• Are the arguments for trade restriction
economically valid?
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8
Comparative Advantage
• Recall from the basic economics principles class:
A country has a comparative advantage in a
good if it produces the good at a lower
opportunity cost than other countries.
Countries can benefit from trade if each
specializes in and exports the goods in which it
has a comparative advantage.
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Comparative Advantage
• Assume:
▫ Two countries: Alpha and Omega
▫ Two goods: milk and bread
• Lets construct the Production Possibilities
Curve/ Frontier
Without Trade
Omega
Bread
Bread
Alpha
If there is no trade,
Alpha chooses
this production and
consumption.
100
50
0
100
If there is no trade,
Omega chooses
this production and
consumption.
B
50
A
100
200
Milk
0
25
50
Milk
Comparative Advantage
Bread
Bread
Since the opportunity cost of milk is lower for Alpha, Alpha has a comparative
advantage in milk. Similarly, Omega has a comparative advantage in bread. If
trade is allowed, Alpha should specialize in milk and Omega should specialize in
bread.
Alpha
Omega
The opportunity
cost of milk is 0.5
bread (the slope of
the PPC)
100
50
0
100
The opportunity
cost of milk is 2
bread
B
50
A
100
200
Milk
0
25
50
Milk
Comparative Advantage
After specialization they trade. The price of milk cannot exceed 2 bread (Omega’s
cost of making it) and cannot fall below 0.5 bread (Alpha’s cost). Assume the
terms of trade (the agreed upon prices) are: 1 milk for 1 bread.
Where will each country end up?
Omega
Bread
Bread
Alpha
200
0
B
50
100
50
With specialization
100
A
100
With Specialization
200
Milk
0
25
50
100
Milk
Gains from trade
• Both countries benefit from trade
• A country is better off specializing in the goods it
has a comparative advantage in
• If a country has a comparative advantage in one
(some) good, it will have a comparative
disadvantage in the other good(s)
Free Trade and Social Welfare
Why the opposition to free trade?
• Distributional consequences: consumers and
producers
• We apply the tools of welfare economics
to show who gains from free trade
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The World Price and
Comparative Advantage
• PW = the world price of a good,
the price that prevails in world markets
• PD = domestic price without trade
• If PD < PW,
▫ country has comparative advantage in the good
▫ under free trade, country exports the good
• If PD > PW,
▫ country does not have comparative advantage
▫ under free trade, country imports the good
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The Small Economy Assumption
• A small economy is a price taker in world
markets: Its actions have no effect on PW.
• Not always true – especially for the U.S. – but
simplifies the analysis without changing its lessons.
17
Social Welfare Without Free Trade
Soybeans Market
P
Without trade:
PD = $4
Q = 500
S
CS
$4
PS
D
500
Q
18
With Free trade: An exporting country
If PW =$6
The country has a
comparative advantage
in Soybeans
Under free trade
▫ domestic
consumers
demand 300
▫ domestic producers
supply 750
▫ exports = 450
P
Soybeans Market
S
exports
$6
$4
D
300 500 750
Q
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Social Welfare with Free Trade
Without trade,
CS = A + B
PS = C
Total surplus
=A+B+C
With trade,
CS = A
PS = B + C + D
Total surplus
=A+B+C+D
Soybeans Market
P
$6
$4
S
exports
A
B
C
D
gains from
trade
D
Q
Free Trade raises social welfare of the exporting country
With Free trade: An importing country
In the absence of trade:
CS = A
PS = B + C
Total surplus=A+B+C
With trade:
CS = A + B + D
PS = C
Total surplus=
A+B+C+D
Plasma TVs
P
S
gains from
trade
A
$300
B
$150
C
D
imports
D
Free Trade raises social welfare of the importing country
Q
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Other Benefits of International Trade
• Product Variety: Consumers enjoy increased
variety of goods.
• Economies of scale: Producers who sell to a
larger market, may achieve lower costs by
producing on a larger scale.
• Foster competition: Competition from abroad
may reduce market power of domestic firms,
which would increase total welfare.
• Trade enhances the flow of ideas, facilitates the
spread of technology around the world.
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Then Why All the Opposition to Trade?
• Trade creates winners and losers.
• The winners from trade could compensate the losers
and still be better off.
• Yet, such compensation rarely occurs.
• The losses are often highly concentrated among
a small group of people, who feel them acutely.
The gains are often spread thinly over many people,
who may not see how trade benefits them.
• Hence, the losers have more incentive to organize
and lobby for restrictions on trade.
International Trade Restrictions
• Despite the benefits of free trade, governments
have often imposed barriers to trade
• Trade Barriers:
▫
▫
▫
▫
▫
Tariff: a tax on foreign goods
Quota: a limit on the quantity of imports
Voluntary restraint agreements
Embargoes: banning trade with a country
Standards: environmental, health or safety
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Analysis of a Tariff on Cotton Shirts
PW = $20
Free trade:
buyers demand 80
sellers supply 25
imports = 55
T = $10/shirt
price rises to $30
buyers demand 70
sellers supply 40
imports = 30
Cotton shirts
P
S
$30
$20
imports
imports
25
40
70 80
D
Q
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Welfare effects of a tariff
Free trade
CS = A + B + C
+D+E+F
PS = G
Total surplus = A + B
+C+D+E+F+G
Tariff
CS = A + B
PS = C + G
Revenue = E
Total surplus = A + B
+C+E+G
P
Cotton shirts
S
A
B
$30
$20
C
D
E
F
G
25
40
70 80
D
Q
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Cotton shirts
P
D = deadweight loss
from substituting
towards domestic
shirts
F = deadweight loss
from the underconsumption
of shirts
S
A
B
$30
$20
C
D
E
F
G
25
40
70 80
D
Q
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Analysis of a Quota on Cotton Shirts
Cotton shirts
P
Quota= 30 shirts
At the price of $20,
there is a shortage
In equilibrium, imports
have to equal 30
buyers demand 70
sellers supply 40
Price rises to $30
$30
S
imports
$20
The quota of 30 shirts
has the same effect as
a tariff of $10
imports
25
40
70 80
D
Q
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Arguments for Restricting Trade
1. The jobs argument
Trade destroys jobs in industries that compete with
imports.
Economists’ response:
Look at the data to see whether rising imports cause
rising unemployment…
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U.S. Imports & Unemployment,
Decade averages, 1956-2005
16%
Imports
(% of GDP)
14%
12%
10%
8%
Unemployment
(% of labor force)
6%
4%
2%
1996
-2005
1986
-95
1976
-85
1966
-75
1956
-65
0%
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Arguments for Restricting Trade
1. The jobs argument
Trade destroys jobs in the industries that compete
against imports.
Economists’ response:
Total unemployment does not rise as imports rise,
because job losses from imports are offset by
job gains in export industries.
Even if all goods could be produced more cheaply
abroad, the country need only have a comparative
advantage to have a viable export industry and to
gain from trade.
Job Protection Argument
 Should policy makers aim at protecting jobs?
“…a U.S. businessman visiting China ….came upon a team of 100
workers building a dam with shovels. He commented to a local
official that, with an earth-moving machine, a single worker could
build the dam in an afternoon. The official replied, "Yes, but think of
all the unemployment that would create."
"Oh," said the businessman, "I thought you were building a dam. If
it's jobs you want to create, then take away their shovels and give
them spoons.” Glassman, James K. "The Blessings of Free Trade,"
The Cato Institute, May 1, 1998. 27 Jan 2010
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Arguments for Restricting Trade
2. The national security argument
An industry vital to national security should be
protected from foreign competition, to prevent
dependence on imports that could be disrupted
during wartime.
Economists’ response:
Fine, as long as we base policy on true security
needs.
But producers may exaggerate their own
importance to national security to obtain protection
from foreign competition.
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Arguments for Restricting Trade
3. The infant-industry argument
A new industry argues for temporary protection
until it is mature and can compete with foreign
firms.
Economists’ response:
Difficult for government to determine which
industries will eventually be able to compete and
whether benefits of establishing these industries
exceed cost to consumers of restricting imports.
Besides, if a firm will be profitable in the long run,
it should be willing to incur temporary losses.
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Arguments for Restricting Trade
4. The unfair-competition argument
Producers argue their competitors in another
country have an unfair advantage,
e.g. due to government subsidies.
Economists’ response:
Great! Then we can import extra-cheap products
subsidized by the other country’s taxpayers.
The gains to our consumers will exceed the losses to
our producers.
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Arguments for Restricting Trade
5. The protection-as-bargaining-chip
argument
Example: The U.S. can threaten to limit imports
of French wine unless France lifts their quotas
on American beef.
Economists’ response:
The threat to limit imports is not a credible threat
since it reduces welfare in the US.
$8
S
6
4
2
D
20
40
60
80
lbs of chocolate