Chapter 17 The Global Economy: Trade
What's in This Chapter and Why
This chapter treats U.S. involvement in world trade. U.S. exports and imports are increasing both
absolutely and relatively.
After describing U.S. participation, the principles of absolute and comparative advantage are
discussed. A two country–two good example are used to illustrate those principles. Gains and
losses from international trade to consumers and producers are separated and it is shown that the
net gain to the society is positive.
Three impediments to international trade--tariffs, quotas, and voluntary export restraintsare
discussed. The cases for and against free trade are then presented. Finally, the global and regional
approaches to reducing trade barriers are discussed.
Instructional Objectives
After completing this chapter, your students should know:
1. That U.S. participation in the world economy is increasing.
2. That trade among nations is based on comparative, not absolute, advantage.
3. That international trade is advantageous in that it allows countries to specialize in the
production of goods in which they have a comparative advantage and exchange those goods for
goods in which they have a comparative disadvantage.
4. That the increase in consumer surplus is greater than the decline in producer surplus and there
are positive net gains from international trade.
5. That tariffs, quotas, and voluntary export restraints serve as impediments to international trade.
6. That society as a whole benefits from free trade, but some individuals are worse off.
Key Terms
These terms are introduced in this chapter:
Trade deficit
Comparative advantage
Comparative disadvantage
Absolute advantage
Absolute disadvantage
Consumers’ surplus
Producers’ surplus
Tariff
Quota
Voluntary export restraints (VERs)
Suggestions for Teaching
In view of increased U.S. participation in the world economy and the importance of the issues, it is
strongly recommended that this chapter be covered. It will take two or three sessions to cover it.
In covering absolute and comparative advantage, some instructors may wish to use a graphical
approach.
In covering the net gains from international trade, concepts of consumer and producer surplus
should be reviewed, and a graphical approach may be more effective.
With regard to reducing international trade barriers, it may be desirable to discuss the World
Trade Organization (WTO) and the future prospects for trade liberalization, both global and
regional.
Additional References
In addition to the references in the text, instructors may wish to read or assign one or more of the
following:
1. Robert E. Baldwin, "Are Economists' Traditional Trade Policy Views Still Valid?" Journal of
Economic Literature 30 (June 1992), pp. 804-829.
2. Jagdish Bhagwati and Marvin H. Kosters (eds.), Trade and Wages: Leveling Wages Down?
(Washington, D.C.: The AEI Press, 1994).
3. Cletus C. Coughlin, K. Alec Chrystal, and Geoffrey E. Wood, "Protectionist Trade Policies: A
Survey of Theory, Evidence and Rationale," Federal Reserve Bank of St. Louis, Review 70
(January/February 1988), pp. 12-29.
4. Robert C. Feenstra, "How Costly is Protectionism?" Journal of Economic Perspectives 6
(Summer 1992), pp. 159-178.
5. David M. Gould, “Has NAFTA Changed North American Trade?” Federal Reserve Bank of
Dallas, Economic Review (Q 1, 1998), pp. 12-23.
6. “Multilateral Trade Negotiations: Issues for the Millennium Round,” Federal Reserve Bank of
St. Louis, Review 82, (July/August 2000), pp. 3-129.
7. John Mutti, Rachelle Sampson, and Bernard Yeung, “The Effects of the Uruguay Round:
Empirical Evidence from U.S. Industry,” Contemporary Economic Policy 18, (January 2000),
pp. 59-69.
8. Overbeek, Johannes, ed. Free Trade Versus Protectionism: A Source Book of Essays and
Readings (Cheltenham, U.K. and Northhampton, Mass.: Elgar, 1999).
9. Andrew Schmitz, Garth Coffin, and Kenneth A. Rosaasen, Regulation and Protectionism
Under GATT: Case Studies in North American Agriculture (Boulder: HarperCollins, 1996).
10. “Symposia: Income Inequality and Trade,” Journal of Economic Perspectives 9 (Summer
1995), pp. 15-80.
Outline
I. U.S. PARTICIPATION IN WORLD TRADE
A. Increased Participation
1. During the last few decades, U.S. imports and exports have increased significantly.
II. COMPARATIVE ADVANTAGE AND INTERNATIONAL TRADE
A. Comparative and Absolute Advantage
1. A country has a comparative advantage in a good or service if it can produce the good
or service at a lower opportunity cost than its trading partner.
2. A country has an absolute advantage if it can produce a good or service with fewer
resources than its trading partner.
3. Countries gain by producing goods and services for which they have a comparative
advantage and exchanging them for goods and services for which they have a
comparative disadvantage.
III. NET GAINS FROM INTERNATIONAL TRADE
A. Importing goods at lower prices than the equilibrium domestic prices increases the
consumer surplus more than it decreasing the producer surplus. The net gains from
international trade is therefore positive.
IV. BARRIERS TO INTERNATIONAL TRADE
A. Tariffs
1. A tariff is a tax levied upon a good when it crosses a nation's border.
2. Because a tariff increases the domestic price of a good, consumers are worse off and
domestic producers are better off.
3. Because a tariff redirects resources from industries that have a comparative advantage
to those that have a comparative disadvantage, society is made worse off.
B. Quotas
1. An import quota specifies the maximum amount of a good that may be imported
during a time period.
2. The effects of a quota are similar to the effects of a tariff.
a. One difference is the fact that a tariff generates revenue for the federal
government; a quota does not.
b. Another difference is the fact that a quota may result in a higher price than a tariff
because imports cannot respond to an increase in demand.
C. Voluntary Export Restraints
1. A voluntary export restraint (VER) is an agreement between importing and exporting
countries whereby exporting nations agree to limit the amount of a good shipped to
importing nations.
2. Like a tariff and quota, a VER increases the price of a good and redirects resources
from industries that have a comparative advantage to those that have a comparative
disadvantage.
V. THE CASE FOR FREE TRADE
A. Decreasing Costs
1. International trade allows some industries to increase output and take advantage of the
lower average production costs that occur at higher levels of output.
B. Increased Competition
1. In some industries, competition from foreign firms is the only way to keep a market
from being dominated by one or a few domestic firms.
C. Diversity of Products
1. International trade increases the diversity of products available to consumers.
VI. THE CASE FOR PROTECTION
A. Infant Industry
1. Some argue that initially a new industry may be unable to compete with corresponding
mature industries in other countries and should be protected.
2. This view is not particularly relevant for mature industrial economies like the United
States.
B. National Defense
1. Some argue that industries producing goods vital to national security should be
protected.
C. Save American Jobs
1. Some argue that some form of protection should be maintained because foreign
competition can reduce employment in import-competing industries.
2. The solution to unemployment in import-competing industries is pursuing policies that
will provide for full employment and policies that will help those workers who become
structurally unemployed.
D. Cheap Foreign Labor
1. Some argue that some form of protection should be maintained because high wages in
the United States keep many industries from being competitive in world markets.
2. If wages are high because productivity is high (as in the United States), then high
wages do not necessarily imply high costs.
VII. REDUCING TRADE BARRIERS
A. The Global Approach
1. Under the auspices of the General Agreement on Tariffs and Trade (GATT) there have
been eight round of international trade negotiations in the post-World War II era.
a. These negotiations have resulted in reductions in tariff rates.
B. The Regional Approach
1. Many countries have formed regional trading blocs.
a. These blocs reduce or eliminate trade barriers among members while maintaining
barriers against countries who are not a part of the bloc.
2. The North American Free Trade Agreement (NAFTA) established a free-trade area for
the United States, Canada, and Mexico.
3. The European Union has 15 members. It has eliminated most trade barriers between
member countries.
Answers to Review Questions
1. Describe the relationship between U.S. exports and imports since 1960.
U.S. exports and imports have increased significantly over the past four decades. Exports rose
from $25 billion in 1960 to $1,034 billion in 2001, and imports increased from $23 billion to
$1,383 billion.
The U.S. economy also grew rapidly over the same time period. GDP was $527 billion in 1960
and $10,082 billion in 2001. The growth of international trade outpaced GDP, however. The
U.S. economy has become increasingly internationalized. Measured by exports, foreign trade
increased from almost 5 percent of GDP in 1960 to nearly 12 percent in 1997, then fell back to
about 10 percent of GDP by 2001. Measured by imports, international trade grew from a little
over 4 percent of GDP in 1960 to a peak of 15 percent of GDP in 2000, then fell back to about
14 percent of GDP in 2001.
2. Describe the behavior of the trade deficit since 1976. What is the political significance of
this trend?
From 1960 to 1976, U.S. exports closely matched U.S. imports. Since then, the U.S. has had a
trade deficit (imports greater than exports). The trade deficit reached a record level of more
than $350 billion - 3.5 percent - of GDP in 2000. Many people see exports as a source of jobs,
and imports as a loss of jobs - in the sense that imported goods and services would have
provided jobs in the U.S. if they had been produced here. They view the rising trend in U.S.
trade deficit as evidence that foreign trade destroys more jobs than it creates and push for
various restrictions on trade as a means of protecting U.S. workers.
3. Distinguish between absolute and comparative advantage.
An absolute advantage refers to a country's ability to produce a commodity with fewer
resources than another country. A comparative advantage refers to a country's ability to
produce a commodity at a lower opportunity cost than another country.
4. Suppose that a worker in the United States is able to produce more beef and more steel
than a worker in Japan. Does this mean that Japan will be unable to trade with the
United States? Defend your answer.
Just because the American worker can produce more of both goods does not imply that Japan
will be unable to trade with the United States. Trade is not based on absolute advantage, but on
comparative advantage. So long as the United States and Japan have different opportunity
costs in the production of goods, there is a basis for trade.
5. Use the information in the table to answer parts a, b, and c.
Country
United States
France
Car Production
per Day
6
1
Wine Production
per Day
2
1
a. Which country has the absolute advantage in cars? In wine?
b. Which country has the comparative advantage in cars? In wine?
c. Is there a basis for trade between the two countries? Explain in detail why or why
not.
a. The United States has the absolute advantage in the production of both cars and wine. It
can produce more of both goods.
b. In the United States, 1/3 unit of wine must be given up to produce an additional car. In
France, 1 unit of wine must be given up in order to produce an additional car. This means
that the Unites States has a comparative advantage in the production of cars.
In the United States, 3 cars must be given up to produce a unit of wine. In France, 1 car
must be given up to produce a unit of wine. This means that France has a comparative
advantage in the production of wine.
c. There is a basis for trade between these countries. The United States would be willing to
trade for wine if it could get more than 1/3 unit of wine for each car. France would be
willing to trade for cars if it could get more than 1 car for each unit of wine.
Suppose the countries agree to trade at the rate of 2 cars for 1 unit of wine. In this case, the
United States will get 1/2 unit of wine for each car it trades to France. It is better off than
if it tried to produce wine. For each unit of wine it gives to the United States, France gets 2
cars. It is also better off as a result of trade. Thus, so long as the opportunity costs of
production differ between the countries, trade can improve their welfare.
6. International trade affects consumers, producers, and workers. Illustrate and explain
why economists normally conclude that free international trade is a good thing for
society, on balance, referring to the effects of international trade on each of these parties.
Price of Cloth
U.S. Supply
A
Pb
B
D
Pa
U.K. Price
C
U.S. Demand
Imports
0
Qd
Qb
Qc
Quantity of Cloth
Consumers, producers and workers are effected differently from international trade. Le us use
the following example to illustrate these effects. Suppose that U.S. imports textile from U.K.
We know that the U.S. can produce cloth, so if textiles are imported from the U.K., U.S. firms
will suffer from losses in sales and some textile workers will lose their jobs. This is true, as far
as it goes, but it is only part of the story. Textiles will not be imported in the real world unless
U.S. consumers value them more highly relative to their price than domestically-produced
textiles. So, although textile imports create losses for workers and producers, they also create
gains for consumers. It turns out, moreover, that gains to consumers exceed losses to workers
and producers.
This result can be demonstrated using supply and demand analysis and some of the measures
related to that analysis that we have used previously. The figure below shows the domestic
market for cloth.
In the absence of supply from the U.K. the market would clear at Qb (the quantity before
international trade) and Pb (the price before international trade). Given that the U.K. has a
comparative advantage in cloth production, however, its opportunity cost of cloth production is
generally lower than in the U.S. This means it can offer its cloth on the U.S. market at a price
below that of most U.S. cloth producers. This is indicated in the figure by a U.K. price (Pa - the
price after trade) that is below the U.S. price of Pb. Given the lower U.K. price,
U.S. consumers will buy Qd from domestic producers, some of whom are more efficient than
their U.K. counterparts. They will consume Qc, however, importing Qc-Qd from lower-cost
producers in the U.K.
With no imports the market would clear at Qb and Pb, producing net gains to consumers
(consumers' surplus) equal to area A and net gains to producers (producers' surplus) equal to
area B+C. With trade, the price will fall to Pa, and consumers will buy Qc; Qd from domestic
producers and Qc-Qd from U.K. producers. Trade will increase the net gains of consumers by
the area B+D and reduce the net gains of producers by area B, leaving a net gain from trade of
area D.
Before the U.K. cloth is available, consumers reap net benefits in this market equal to the
difference between what they would pay for the cloth they buy, their demand price, and the
price they must pay, Pb. Their net benefit, or consumers' surplus, is equal to area A. Before the
U.K. cloth is available, U.S. producers enjoy net benefits equal to the difference between the
price they receive, Pb, and what they must receive to cover costs, i.e., their supply price. Their
net benefit, or producers' surplus, is equal to area B+C.
After cloth is imported from the U.K., consumers gain additional consumers' surplus of B+D
and producers lose producers' surplus of B. The gain in consumers' surplus is larger than the
loss in producers' surplus by the area D. Area D represents the net gains from trade for cloth
with the U.K.
U.S. production will fall from Qb to Qd, however. Because of this, some U.S. workers will lose
their jobs. There is a net loss to workers, however, only to the degree that they are unable to
find alternative employment. Under normal conditions, an economy at or close to full
employment, they will find other jobs and net losses to workers will be small.
7. Compare and contrast the different restrictions that the United States might place on
steel imports.
There are several different restrictions that might be placed on steel imports. First, the United
States might place a tariff on steel imports. In this case, a tax would be levied on all steel that
enters the country. The effect of the tariff would be to increase the domestic price of steel. As
price increased, domestic steel producers would be made better off. The price increase would
make consumers worse off. Government would be made better off because it would gain some
revenue from the imposition of the tariff. Finally, society as a whole would be worse off. This
occurs because the tariff would redirect resources from those industries that have a comparative
advantage to those that have a comparative disadvantage.
Instead of a tariff, the United States might place a quota on steel imports. The quota would
specify the maximum amount of steel that could enter the country. Like the tariff, this would
drive up the price of steel making domestic producers better off and consumers worse off.
Society would also be worse off because resources would be redirected to industries that have a
comparative disadvantage. Unlike the tariff, a quota would generate no revenue for the
government. Further, it is possible that prices would increase more under the quota. If demand
for steel increased, imports could not respond (as they might under a tariff), and the price
increase would be greater.
Finally, the United States could negotiate a voluntary export restraint (VER) with countries
exporting steel into the country. A voluntary export restraint is an agreement between
importing and exporting countries under which exporting nations agree to limit the amounts
that they ship to importing nations. The effects of a voluntary export restraint are like those of
quotas. The domestic price of steel would rise. Domestic producers would be better off and
domestic consumers worse off. Society's welfare would fall because resources would be
directed to industries having a comparative disadvantage. No governmental revenue would be
generated. The basic difference between a VER and a quota is the fact that the VER is
voluntary. The United States and other countries would reach a mutual agreement limiting
imports. A quota is not voluntary. The United States simply imposes a restriction limiting
imports.
8. How is each of the following affected by a tariff? An import quota?
a. consumers
b. domestic producers
A tariff is a tax levied on a good when it crosses a nation’s borders. This causes the domestic
price of the good to rise. The consumer is worse off because of the tariff because they are
forced to pay a higher price for the good. The domestic producer is better off. They receive a
higher price for the product, but are not subject to the tax. This also allows them to increase
production.
A quota specifies the maximum amount of a good that may be imported during any time
period. The limitation of quantity causes domestic price to rise. Therefore, the consumer is
worse off because of the quota. Domestic producers, again, are better off because they receive
a higher price for their product and can increase output.
9. What is the infant industry argument? Is it likely to be valid for a mature economy like
that of the United States? If valid, what would be a better solution than imposing trade
restrictions?
Some claim that certain emerging industries should be protected (as one would protect a small
child) because, once they are established, they will have a comparative advantage. Initially,
however, they will be unable to compete with industries already established in other countries.
According to this argument, the protection is temporary. It would be eliminated as the industry
becomes competitive in world markets.
This argument is not particularly valid for a mature economy like the United States, although
the automobile industry has successfully used this argument to receive protection from foreign
competition. They claimed to need some time to modernize in order to become more
competitive. Unfortunately, modernization tends to come more quickly in the face of
competition. Economists tend to agree that tariffs and quotas are not the best methods to help
emerging industries become competitive. Instead, direct subsidies would be a better approach.
Subsidies have several advantages: prices remain low, it is clear what industries are being
helped and to what extent, and subsidies are easier to eliminate.
10. "If we allow free trade in the automobile industry, some automobile workers will lose
their jobs. This unemployment will make society worse off." What advantage of free
trade does this argument overlook? How might the unemployment be alleviated?
The basic advantage of free trade ignored by this argument is the fact that free trade is based on
the principle of comparative advantage. If free trade prevails, countries will produce those
goods in which resources are used most efficiently. If restrictions are imposed, jobs may be
saved in some industries; however, jobs in other industries will be lost as resources are
redirected. Further, the jobs saved will be in those industries that are less efficient. Hence,
resources are directed away from efficient industries to inefficient industries.
To maintain full employment, policymakers could use fiscal and monetary policy. Also,
because it may be difficult for some workers to relocate due to skill obsolescence,
policymakers may need to implement programs to retrain and relocate workers.
11. Suppose U.S. wage rates are higher than those abroad. Is there a basis for trade between
the United States and the rest of the world? Defend your answer.
U.S. wage rates probably are higher than in most foreign countries; however, there is good
reason for this. U.S. workers are well trained and work with relatively large amounts of
capital. It is not surprising that they are very productive and earn high wages as a result. Thus,
it is not safe to say that high wages in America imply high costs.
Even if high wages did give the U.S. an absolute disadvantage in the world market, other
countries would still find it advantageous to trade with the U.S. Remember, trade is based on
comparative advantage, not absolute advantage.
12. Despite the fact that society is generally better off with free trade, governments often
impose trade barriers. Explain why government might take such action.
Often, restrictions are imposed because of the political pressure of special interest groups. The
political process may cause a bias in favor of the programs of special interest groups. These
programs tend to bestow a large amount of benefits upon a few individuals (those that compose
the special interest group). As a result of these large benefits, special interest groups may be
willing to commit large quantities of resources to politicians to ensure passage of the desired
program. These resources are beneficial to the politician because they can be used in political
campaigns to ensure re-election.
These same programs may generate large aggregate costs; however, because the costs are
spread over all members of society, only a small cost upon may be imposed upon each
individual. Because of this small individual cost, the majority may have no interest in devoting
resources to ensure that the politician is not re-elected because of his or her support for
inefficient programs.
13. Compare and contrast the global and regional approaches to reducing barriers to
international trade.
Both the global and regional approaches to reducing barriers to international trade are designed
to enhance international trade. The global approach has been a series of international trade
negotiations conducted under the auspices of the General Agreement on Tariffs and Trade
(GATT). There have been eight rounds of negotiations in the post-World War II era. Each
round has resulted in reductions in tariff rates.
Under the regional approach, countries form regional trading blocs. Barriers to trade are
reduced or eliminated for members of the bloc. Barriers are maintained against countries
outside the bloc. The North American Free Trade Area and the European Union are two
examples of such blocs.
14. What is the World Trade Organization (WTO)? Why are environmentalists and other
groups disappointed in the WTO?
Formed in 1995, the WTO is comprised of approximately 120 nations, including the United
States. The organization was formed as a successor to the General Agreement on Tariffs and
Trade (GATT). The WTO provides a framework for multilateral trade negotiations, issues
ground rules for the conduct of international trade, and helps to resolve trade disputes. Most
criticisms of the WTO date back to GATT, but environmentalists, in particular, have not been
happy with GATT/WTO.
Environmentalist groups disagreed with GATT in 1991 when GATT ruled against the United
States’ embargo on tuna caught by foreign fleets (which endangered dolphins). In 1998,
environmentalists were again upset with WTO when they ruled against U.S. restrictions on
imports of shrimp caught in nets without adequate means to protect sea turtles.
15. Trade negotiations are complex and lengthy. Explain why they may be even more
complex and time consuming in the future.
Trade negotiations promise to become more complex in the future as some parties attempt to
link the negotiations to labor and environmental standards. Those who favor this argue that
less developed countries have poor working conditions and less stringent environmental
standards than the U.S. Trade agreements offer an opportunity to raise those standards.