chapter TWENTY-Four
International Trade
This chapter builds on Chapter 6, providing more analysis of international trade and protectionism. First, it reviews important facts about world trade. Second, it examines how international specialization based on comparative advantage can mutually benefit participating nations. Third, supply and demand analysis is used to help students understand prices and quantities of imports and exports. Fourth, the economic impact of trade barriers is examined, followed by the arguments for protectionism. Finally, the chapter discusses the costs of protectionism and some continuing international trade controversies.
After completing this chapter, students should be able to
1. Summarize the importance of international trade to the U.S. in terms of overall volume.
2. List the major imports and exports of the United States.
3. State two economic points that explain why nations trade.
4. Compute, when given appropriate data, the relative costs of producing two commodities in two countries and determine which nation has the comparative advantage in each good.
5. Compute, when given appropriate data, the range for the terms of trade.
6. Calculate the potential gains from trade and specialization for each nation and the world when given appropriate data.
7. State the economist’s case for free trade.
8. Explain the relationship between world prices and the American export supply curve, and the relationship between world prices and the American import demand curve.
9. Explain international equilibrium price and quantity using a two-nation market model for import demand and export supply.
10. Identify four types of trade barriers.
11. Describe the economic impact of tariffs, including both direct and indirect effects.
12. Contrast the economic impact of a quota with that of a tariff.
13. List seven arguments in favor of protectionist barriers and critically evaluate each.
14. Identify the costs of protectionist policies and their effects on income distribution.
15. Describe the major provisions of the WTO, and explain why some protest against the WTO.
16. Define and identify terms and concepts listed at the end of the chapter.
I. Facts of International Trade: Highlights
A. Exports of goods make up about 11% of total U.S. output.
B. The U.S. leads the world in the volume of exports and imports with about 1/8 of the total.
C. Since 1975 U.S. exports and imports have more than doubled as a percentage of GDP.
D. In 2002 the U.S. had a goods and services trade deficit of $435 billion dollars. The U.S. was a net exporter of services ($49 billion).
E. The principal exports of the U.S. are computers, chemicals, semiconductors, consumer durables, and aircraft. Its main imports are petroleum, automobiles, computers, and clothing.
F. The U.S. exports many of the “same” goods it imports. (Intraindustry trade)
G. The bulk of U.S. trade is with other industrialized nations.
H. Improved transportation and communication has contributed greatly to international trade since WWII.
I. Although the U.S., Japan, and Western Europe dominate world trade, there are emerging nations around the world that collectively generate substantial international trade such as South Korea, Taiwan, Singapore, and China. The North American Free Trade Agreement (NAFTA) has expanded trade among Canada, Mexico, and the U.S.
J. International trade and finance link economies. Economic change in one part of the world has repercussions for countries around the globe.
K. International trade and finance is often at the center of U.S. economic policy.
II. The Economic Basis for
Trade
A. International trade is a way nations can specialize, increase the productivity of their resources, and realize a larger total output than they otherwise would.
B. Two points amplify the rationale for trade.
1. The distribution of economic resources among nations is uneven.
2. Efficient production of various goods requires different technologies or combinations of resources.
3. Products are differentiated among nations and some people prefer imports.
C. Interaction of these points can be illustrated.
1. Japan has a large, well‑educated labor force and can specialize in labor‑intensive commodities.
2. Australia has an abundance of land relative to human and capital resources and can cheaply produce land‑intensive agricultural products.
3. Industrially advanced nations (including Japan) are in a position to produce capital‑intensive goods.
D. As
national economies evolve, the resource base may be altered affecting the
relative efficiency with which
nations can produce various goods and services.
III. Graphical Analysis of
the Principle of Comparative Advantage
A. The basic principle of comparative advantage rests on differing opportunity costs of producing various goods and services.
B. An example of comparative advantage is developed in Figure 37-1 and Table 37-1 comparing an imaginary example using the U.S. and Brazil.
1. Before trade, both nations are self‑sufficient in wheat and coffee and produce at the levels shown in Figure 37‑1.
2. The principle of comparative advantage says that total output will be greatest when each good is produced by the nation that has the lower opportunity cost. The U.S. has a comparative advantage in wheat production and should specialize in wheat, and Brazil should specialize in coffee as one would expect.
3. Note in Table 37‑1 that after specialization there will be more coffee and more wheat in total than the totals before specialization. Total wheat production rose from 26 units of wheat to 30 units of wheat; coffee production rose from 16 to 20.
4. Since each nation would like some of both goods, they will now have to trade. The terms of trade will be limited by the original cost conditions in each country. For example, in the U.S. 1 wheat = 1 coffee, so the U.S. will not give up more than 1 wheat for each coffee. Similarly, in Brazil 1 wheat = 2 coffee, so Brazil will not trade more than 2 coffee for 1 wheat. These two facts set the limits to the terms of trade. The rate of exchange will be somewhere between 1 and 2 coffees for each wheat (Figure 37‑2 illustrates these possibilities graphically). The actual terms of trade within these limits will depend on each country’s negotiating power and world demand and supply conditions for these products.
5. The gains from trade can be shown by selecting any trade ratio within the limits. The text selects 1W = 1-1/2C. If the U.S. chooses to trade 10 tons of wheat for 15 tons of coffee, both nations will be better off than they were when they were self‑sufficient. Specialization and trade have improved the productivity of their resources.
6. As a result of specialization and trade, both countries can have more of both products.
7. The above example assumes constant cost industries, which would not be the case in the real world. Rather, as the U.S. begins to expand wheat production, its relative costs will rise and likewise with costs of coffee production in Brazil. The effect of increasing costs is that complete specialization will probably not occur with many products.
C. The case for free trade is restated in the text: Through free trade, based on the principle of comparative advantage, the world economy can achieve a more efficient allocation of resources and a higher level of material well‑being. (See Figure 37-2 (Key Graph).)
1. One side benefit from free trade is that it promotes competition and deters monopoly power.
2. Another side benefit may occur as specialization increases the production possibility curve by raising the productivity of the resources devoted to producing certain goods.
3. Free trade links national interests, potentially breaking down national animosities.
4. Try Quick Quiz 37-2.
IV. Supply and Demand
Analysis of Exports and Imports
A. This analysis helps us understand how prices and quantities of exports and imports are determined in world markets.
1. The equilibrium world price derives from the interaction of world supply and demand.
2. The equilibrium domestic price is determined by domestic supply and demand. It is the price that would prevail in a closed economy with no international trade.
3. When economies are open to trade, differences between world and domestic prices form the basis for exports or imports.
B. Supply and demand in the U.S.
1. Assume first that there are no trade barriers, that Canada is the only other nation in the world, that aluminum is the product in question, and that there are no international transportation costs, to keep the analysis simple.
2. Figure 37-3a shows the domestic supply and demand curves for aluminum in the U.S. with an equilibrium price of $1 per pound and an equilibrium quantity of 100 million pounds.
3. If the world price exceeds $1, American firms will increase production and export the excess output to the rest of the world (Canada).
a. If the world price is $1.25, then American producers will supply 50 million pounds for export. (See Figure 37-3)
b. If the world price rises to $1.50, Americans will have 100 million pounds to export, because domestic consumers will buy only 50 million pounds at that price.
c. The American export supply curve is found in Figure 37-3b by plotting the domestic surpluses occurring at world prices above the $1 domestic equilibrium price. When world prices rise relative to American domestic prices, U.S. exports rise.
4. U.S. import demand will be shown by the Figure 37-3b plot of the excess domestic demand created if prices fall below the $1 domestic equilibrium price. The downsloping curve shows the amount of aluminum imported by the U.S. at prices below the $1 American domestic price. When world prices fall relative to domestic prices, American imports rise.
C. The supply and demand of aluminum in Canada can be depicted in a similar manner, as shown in Figure 37-4. The prices have been converted into U.S. dollar equivalents using the exchange rate mechanism discussed in Chapters 6 and 38.
1. Canada’s import demand curve represents domestic shortages in Canada when the world price falls below the $.75 domestic Canadian price.
2. Canada’s export supply curve represents domestic surpluses in Canada when the world price is above the $.75 Canadian domestic price.
D. Determination of the equilibrium world price, of exports and imports is illustrated in Figure 37-5.
1. Equilibrium occurs in this two-nation model where one nation’s import demand curve intersects another nation’s export supply curve. In this example, this occurs at a price of $.88.
2. At the $.88 world price, the domestic prices in both Canada and the U.S. will also be $.88.
E. Canada will export aluminum to gain earnings to buy other goods, such as computer software, that are made in the United States. These exports enable Canadians to acquire imports that have greater value to them than exported aluminum. Otherwise, they would be willing to pay more than $.88 per pound for aluminum. (Key Question 7)
V. Trade Barriers: Barriers to free trade do exist.
A. Types of barriers:
1. Tariffs are excise taxes on imports and may be used for revenue purposes, or more commonly as devices that protect domestic producers from foreign competition by raising import prices.
2. Import quotas specify the maximum amounts of imports allowed in a certain period of time. Low import quotas may be a more effective protective device than tariffs, which do not limit the amount of goods entering a country.
3. Nontariff barriers refer to licensing requirements, unreasonable standards, or bureaucratic red tape in customs procedures.
4. Voluntary export restrictions are agreements by foreign firms to “voluntarily” limit their exports to a particular country. Japan has voluntary limits on its auto exports to the United States.
B. The economic impact of tariffs is shown in Figure 37-6. With free trade, consumption will take place at the world price Pw, and domestic production will be 0a with imports making up the difference, ad. There are 4 direct effects.
1. When the tariff is imposed, domestic consumption declines to 0c as the price rises to Pt.
2. Domestic production will rise to 0b because the price has risen.
3. Imports fall to bc from ad.
4. Government tariff revenue will represent a transfer of income from consumers to government.
5. One indirect effect also may occur in that relatively inefficient industries are expanding and relatively efficient industries abroad have been made to contract.
C. The economic impact of quotas is similar to tariffs, but worse because no revenue is generated for the government; the higher price results in more revenue per unit for the foreign producer. After the quota, the price will rise to Pt as with the tariff, but the entire amount of revenue generated by the higher price will go to the foreign and domestic producers supplying the product at price Pt. Also, there is no possibility for consumers to obtain more than the allowed quota, even at higher prices.
VI. The Case for Protection: A Critical Review
A. Military self‑sufficiency may be a valid political‑economic argument for protecting industries that are critical to national defense. The argument is that the country cannot be dependent on other countries for its national defense. However, the problem with this rationale is that nearly every industry is critical in one way or another. It is difficult to select strategic industries to protect. Also, most goods are produced in many places, so dependency on one nation is not likely.
B. Increasing domestic employment is the most popular reason for protection, but there are important shortcomings associated with this reasoning.
1. Imports may eliminate some jobs, but they create others in the sales and service industries for these products.
2. The fallacy of composition applies here. The imports of one nation are the exports of another. By achieving short‑term employment goals at home, the trading partner may be made weaker and less able to buy the protectionist nation’s products.
3. Retaliation is a risk that occurred in the 1930s when high tariffs were imposed by the U.S. Smoot‑Hawley Tariff Act of 1930. Protectionism against American goods will hurt our export industries. Such trade wars still erupt today although the WTO helps to eliminate the problem.
4. Long‑run feedbacks relate to the fact that continued excess of exports over imports leads to a shortage of dollars abroad, which foreigners need to purchase more American goods and services; a nation must import in order to export.
C. Diversification for stability may be a legitimate reason for a nation to protect certain industries until they become viable. For example, Saudi Arabia may not always be able to depend on oil exports nor Cuba on sugar exports. They need to develop other industries.
1. This argument does not apply to the U.S. or other diversified economies.
2. The economic costs of diversification may be great and not worth the protection.
D. The infant‑industry argument is similar to the diversification argument for protection. New industries allegedly may need “temporary” protection to gain productive efficiency. But qualifications must be noted.
1. It is difficult to determine which industries are the best to protect.
2. Protection may persist after industrial maturity is realized.
3. Direct subsidies may be preferable to international protection.
E. Strategic trade policy has been successful in Japan and South Korea, but there is still a danger of retaliation by affected nations. Affected nations can implement tariffs in response.
F. Protection against “dumping” is another argument for tariffs when nations “dump” excess products onto U.S. markets at below cost.
1. These firms may be trying to drive out U.S. competition.
2. Dumping can be a form of price discrimination.
3. Dumping is a legitimate concern and is prohibited under U.S. trade law. The Federal government has the right to impose antidumping duties (tariffs) on the goods that were “dumped,” but it may be difficult to prove the below‑cost sales in the first place.
G. Protection is said to be needed against the competition from cheap foreign labor. However, this argument is not valid. It is mutually beneficial for rich and poor to trade with one another. By not trading, we don’t raise our living standards at all, but we will decrease them by shifting labor into inefficient areas where the foreign labor could have produced the items more efficiently.
H. A summary of arguments suggests that only two arguments for protection are really valid and they are tough to apply. The infant‑industry argument and the military self‑sufficiency argument may be justifiable on political grounds. Most other arguments are based on emotional half‑truths or outright fallacies. Evidence of the results of protectionism shows that it has not had positive effects.
I. CONSIDER THIS … Shooting Yourself in the Foot
Just as gunslingers in the Wild West would occasionally pull the trigger too soon and shoot themselves in the foot, hurting themselves more than their adversary. Nations that impose trade barriers often hurt themselves. The nations they boycott or impose tariffs against have less of the boycotting nation’s currency to buy their exports, and they may retaliate with barriers of their own.
J. Summing Up.
1. Within the U.S., the Constitution says states cannot prevent trade, so we have a prosperous, huge free‑trade area.
2. The European Union has prospered as trade barriers have been eliminated.
3. The world economy has grown under the trend toward more tariff reduction since the mid‑1930s.
4. High tariffs were a factor in causing the Great Depression.
5. Nations with high protectionist policies have slower growth than those with no barriers.
VII. The World Trade
Organization
A. Inefficiencies of protectionism have led nations to seek ways to promote free trade.
B. In 1994 the more than 120 member nations of the World Trade Organization (WTO) agreed to implement several policies by 2005. These policies include
1. Reducing tariffs worldwide.
2. Adopting new rules to promote service trade.
3. Reducing in agricultural subsidies that protect less-efficient farmers.
4. Providing new protection for intellectual property.
5. Phasing out of quotas on textiles and clothing, replacing them with gradually declining tariffs.
C. These policies are predicted to boost trade by 8% or $6 trillion.
D. WTO today.
1. 145 nations belong as of late 2001.
2. The organization oversees provisions of agreement and resolves disputes.
3. It has become a protest target of groups who are against various aspects of globalization.
E. Economists favor free trade with labor and environmental protections.
VIII. LAST WORD: The WTO Protests
A. The WTO became well known in November 1999, with the sometimes violent protests of the WTO in Seattle.
B. Protesters included labor unions, environmental groups, socialists, anarchists, and a few other, more specialized interests.
C. Labor protection standards were a major point of contention.
1. Protesters called for international trade rules to include collective bargaining rights, minimum wages, workplace safety standards, and prohibition of child labor.
2. Developing nations, whom these protections were intended to benefit, opposed the protestors’ demands, as they would have hurt the developing nations’ competitive position and workers.
3. The WTO wants to liberalize trade through multilateral negotiation, and allow nations to determine their own labor standards.
D. Environmental standards are another source of criticism of the WTO.
1. Critics contend that trade liberalization will encourage environmental degradation and would like the WTO to establish environmental standards.
2. The WTO believes that environmental standards would benefit industrially advanced countries by raising costs in developing countries, and that the best way to achieve environmental improvements is by raising incomes and people’s demand for a cleaner environment.
E. The objectives of the protesters to achieve better conditions for labor and the environment are noble, but in the eyes of the WTO will best be achieved by strong economic growth and improved living standards. This will enable all nations to “buy” more of these protections.