International Trade and Public Policy 285

International Trade

and Public Policy

Chapter Summary

This chapter discusses the benefits of specialization and trade and explores the trade-offs associated with protectionist policies. Here are the main points of the chapter:

· If one country has a comparative advantage vis-à-vis another country in producing a particular good (a lower opportunity cost), specialization and trade will benefit both countries.

· An import ban or an import quota increases prices, protecting domestic industries, but domestic consumers pay the price.

· Because the victims of protectionist policies often retaliate, the protection of a domestic industry can harm an exporting industry.

· A tariff, a tax on imports, generates revenue for the government, whereas an import quota—a limit on imports—generates revenue for foreigners or importers.

· In principle, the laws against dumping are designed to prevent predatory pricing. In practice, predatory pricing laws are often used to shield domestic industries from competition. Allegations of it are hard to prove.

· Under World Trade Organization (WTO) rules, each country may pursue its environmental goals only within its own borders.

· International trade has contributed to the widening gap between the wages of low-skilled and high-skilled labor. However, it also has reduced the relative prices facing the poor, offsetting some of the effects on inequality.

Applying the Concepts

After reading this chapter, you should be able to answer these four key questions:

1. Do tariffs (taxes on imported goods) hurt the poor disproportionately?

2. How much does it really cost to “save” a job that might be lost under free trade?

3. Does the concept of “unfair” competition make sense?

4. Why might international trade reduce measured inequality in the United States?

18.1 Benefits from Specialization and Trade

Trade (voluntary exchange) between individuals and nations is based on the principle of opportunity cost.

Principle of Opportunity Cost

The opportunity cost of an item is what you must sacrifice to get the item.

Table 18.1 shows the opportunity costs of each good in Shirtland and Chipland. Chipland can produce either 120 shirts in one day or 120 chips in one day. This means that if it gives up production of 120 shirts, it gets 120 chips. The opportunity cost of a chip is then one shirt. Similarly, the opportunity cost of a shirt is one chip.

In Shirtland, giving up 108 shirts yields only 36 chips so the opportunity cost of a chip is 3 shirts. This is calculated as the 108 shirts sacrificed divided by the 36 chips gained. Similarly, the opportunity cost of a shirt is 1/3 of a chip. This is calculated as the 36 chips sacrificed divided by the 108 shirts gained.

Figure 18.1 shows the production possibilities curves for Shirtland and Chipland. The production possibilities curve shows the possible combinations of products that an economy can produce, given that its productive resources are fully employed and efficiently used.

2 Remember

With no trade, an economy’s production possibilities frontier also shows the possible consumption possibilities for the economy.

Chipland has the absolute advantage over Shirtland in the production of both chips and shirts. Absolute advantage is the ability of one person or nation to produce a product at a lower resource cost than another person or nation. Another way to think of this is that an economy has an absolute advantage in a good when it can produce more of that good in a given amount of time than can another economy.

Trade is based on comparative advantage. Comparative advantage is the ability of one person or nation to produce a good at a lower opportunity cost than another person or nation. Since the cost of a shirt is 1/3 of a chip in Shirtland, and one chip in Chipland, Shirtland should produce shirts since it has the comparative advantage, or lower opportunity cost. Chipland should produce chips since it gives up fewer shirts to produce a chip. Chipland has a comparative advantage in chip production because it has a lower opportunity cost for chips.

2 Remember

Even though Chipland can produce more shirts and more chips than Shirtland, it is still in Chipland’s best interest to trade with Shirtland. This is because trade is based on comparative advantage—who can produce a good at the lowest opportunity cost.

Based on comparative advantage, Chipland will produce chips and buy shirts. Shirtland will produce shirts and buy chips. The terms of trade can be found from the opportunity costs for the two goods. The terms of trade is the rate at which units of one product can be exchanged for units of another product.

How many shirts will Shirtland give up to buy a chip? If Shirtland produced chips on its own, it would give up 3 shirts for each chip. This is Shirtland’s opportunity cost, and the most it would be willing to pay for a chip. Chipland gives up one shirt each time it produces a chip and this is the least it would be willing to accept in trade for one chip. As a result, one chip will trade for somewhere between 1 and 3 shirts. Notice that these are simply the opportunity costs of the goods for each nation. Any trade between these two values will make both countries better off.

$ Study Tip

Terms of trade are given by the opportunity costs of goods in the trading countries.

The consumption possibilities curve is a curve that shows the combinations of two goods that can be consumed when a nation specialized in a particular good and trades with another nation. We use the consumption possibilities curve to show the gains to Shirtland and Chipland from trading.

In Figure 18.2 Panel A, we have the production possibilities curve for Chipland. Suppose that we start at point g, with Chipland producing 120 computer chips per day. If Chipland tried to produce shirts, it would have to give up one chip for each shirt. Suppose the terms of trade are 2 shirts per chip. Now when Chipland gives up a chip, instead of the one shirt it could receive if it produced shirts, it receives 2 shirts from Shirtland in return for selling a chip to Shirtland. At these terms of trade, Chipland is better off as it can now consume 119 chips and 2 shirts instead of the 119 chips and 1 shirt it could produce, and consume, without trade.

Panel B illustrates that Shirtland is better off as well. Starting from point a, if Shirtland wanted to produce a computer chip, it would have to give up three shirts without trade. By trading, Shirtland can send 2 shirts to Chipland and receive 1 chip in return. Thus, Shirtland is able to consume 106 shirts and 1 chip with trade instead of the 105 shirts and 1 chip it would have without trade.

$ Study Tip

The consumption possibilities curve shows that trade allows countries to consume combinations of goods they could not produce on their own.

Trade rearranges employment in the two countries as well. As a result of trade, Chipland will choose to buy shirts instead of producing shirts. This means that workers in the shirt industry in Chipland will no longer be needed to make shirts. At the same time, Chipland will specialize in making chips and the chip industry will expand and this will increase the employment of chip makers.

18.2 Protectionist Policies

Figure 18.3 illustrates the effects of an import ban in Chipland. With trade, the shirt market is in equilibrium at point c with a price of $12 and a quantity of 80 shirts. All of these shirts are imported as no domestic supplier will sell shirts if the price is below $17. Without imports, the market supply shifts to the left (as the shirts from other countries are no longer offered for sale in Chipland) and the market reaches equilibrium at point a with a price of $25 and 60 shirts sold with all 60 shirts coming from domestic suppliers.

An import quota is a government-imposed limit on the quantity of a good that can be imported. Import quotas are illegal under international trading laws, however, exporting countries may agree to a voluntary export restraint. A voluntary export restraint is a scheme under which an exporting country voluntarily decreases its exports. A voluntary export restraint functions in the same way as an import quota. A tariff is a tax on imported goods. At times governments will issue import licenses, rights, issued by a government, to import goods.

$ Study Tip

Any restriction on imports can be analyzed as a decrease in supply in the affected market.

Figure 18.4 illustrates the impact of these trade restrictions. As long as some imports are allowed, the supply curve will shift to the left relative to the free-trade supply curve but will not shift as far left as the zero import case in Figure 18.3. Notice that the restriction on imports leads to an equilibrium at point d with a higher price and lower quantity than those under free trade. Point e shows the quantity supplied by domestic producers.

The price of shirts will increase to $20 regardless of whether a quota or tariff is used. The difference in the two approaches is who receives the $8 increase in price. With a tariff, this money is collected by the government and so in Figure 18.4 the $8 increase in price for the 44 imported units would be collected as tax revenue by the home government. With a quota, importers and producers receive the extra $8 on those units.

Let’s review an Application that answers one of the key questions we posed at the start of the chapter:

1. Do tariffs (taxes) on imported goods hurt the poor disproportionately?

APPLICATION 1: THE IMPACT OF TARIFFS ON THE POOR

Studies have found that the poor bear a larger burden from tariffs than do the rich. The first reason is that goods subject to a tariff tend to make up a larger part of the spending of the poor. The second reason is that most tariffs are applied to low priced, imported items, thus raising the price on goods that tend to be purchased more frequently by the poor.

18.3 What Are the Rationales for Protectionist Policies?

There are three primary reasons for restrictive trade policies:

· To shield workers from foreign competition.

· To nurture infant industries until they mature.

· To help domestic firms establish monopolies in world markets.

In many cases, industries affected by trade, such as textiles in the United States, are concentrated in relatively small parts of the United States. Politicians in those areas use trade policy to protect their constituents, even though it may cost other citizens.

Nurturing infant industries is justified in part by the concept of learning by doing. An infant industry is one that is at an early stage of development. Learning by doing refers to knowledge and skills workers gain during production that increase productivity and lower cost. As the industry matures, costs fall and the protection is less needed.

Airbus is an example of European governments using trade restrictions to assist a domestic firm to gain market share.

Let’s review two Applications that answer key questions we posed at the start of the chapter:

2. How much does it really cost to “save” a job that might be lost under free trade?

APPLICATION 2: MEASURING THE COSTS OF PROTECTING JOBS

This Application illustrates the cost of saving U.S. jobs in certain industries. The Application states that each textile job saved from moving abroad costs the United States $199,241. The Application shows the five costliest jobs to save, with jobs in three industries costing the United States over $1 million per year to preserve.

3. Does the concept of “unfair” competition make sense?

APPLICATION 3: PROTECTION FOR CANDLE MAKERS

This Application reprints a satirical petition from the 1800s on behalf of French candle makers for protection from competition from the sun.

18.4 A Brief History of International Tariff and Trade Agreements

This section describes a few major pieces of trade agreement.

The General Agreement on Tariffs and Trade (GATT) is an international agreement established in 1947 that has lowered trade barriers between the United States and other nations. The World Trade Organization was established in 1995 and oversees GATT and other international trade agreements, resolves trade disputes, and holds forums for further rounds of trade negotiations. The North American Free Trade Agreement (NAFTA) will eliminate all trade barriers between the United States, Canada, and Mexico. The European Union was formed to eliminate trade barriers between member states. The Asian Pacific Economic Cooperation was created to lower trade barriers between 18 member Asian nations. The U.S.-Central American Free Trade Agreement, if approved, will extend NAFTA-like provisions to five Central American countries.

18.5 Recent Policy Debates and Trade Agreements

There are three recent policy debates discussed in this chapter:

1. Are foreign producers dumping their products?

2. Do trade laws inhibit environmental protection?

3. Does outsourcing and trade cause income inequality?

Dumping is a situation in which the price a firm charges in a foreign market is lower than either the price it charges in its home markets or the production cost. One reason we might see different prices between countries is price discrimination. Price discrimination is the process under which a firm divides consumers into two or more groups and charges a different price for each group buying the same product. A second reason is predatory pricing, a pricing scheme under which a firm decreases the price to drive rival firms out of business and increases the price when rival firms leave the market. It is very difficult to determine whether low prices in a market are caused by price discrimination, predatory pricing, or simply more competition in that market.