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CHAPTER

International
Trade
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20

CHAPTER INTRODUCTION

Why do countries trade?

Hong Kong has no oilhow is it going to


get it?

What is comparative advantage?

Bananas could be grown in the most


tropical parts of the United States or in
expensive greenhouses, but wouldnt it
be easier to import bananas from
Honduras?

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Stop for a moment and imagine a world


without international trade.

Chocolate is derived from cocoa beans that


are imported from South America and Africa.

There are imported cars from Germany and


Japan, shoes and sweaters from Italy, shirts
from India, and watches and clocks from
Switzerland.

Consumers love trade because it provides


them with more choices.

It is good for producers, too; the speed of


transportation and communication has
opened up world markets.

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In addition, lower costs are sometimes


the result of economies of scale.

Free trade gives firms access to large


world markets.

It also fosters more competition, which


helps to keep prices down.

In this chapter, we extend our coverage


to international trade.

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20.1 The Growth in World Trade

In a typical year, about 15 percent


of the world's output is traded in
international markets.

The importance of the international


sector varies enormously from place
to place across the world.

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Importance of International Trade

In the last three decades, the sum


of U.S. imports and exports has
increased from 11 percent of GDP to
roughly 30 percent.

In addition, incoming and outgoing


investments have risen from less
than 1 percent to roughly 3 percent
of GDP.

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U.S. exports include capital goods,


automobiles, industrial supplies,
raw materials, consumer goods, and
agricultural products.

U.S. imports include crude oil and


refined petroleum products,
machinery, automobiles, consumer
goods, industrial raw materials,
food, and beverages.

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Trading Partners

In its early history, U.S. international


trade was largely directed toward
Europe and to Great Britain in
particular.

Now the U.S. trades with a number


of countries, the most of which are
shown in Exhibit 1.

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Major U.S. Trading Partners

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20.2 Comparative Advantage

and Gains from Trade

The very existence of trade suggests


that trade is economically beneficial.

Because almost all trade is voluntary, it


would seem that trade occurs because
the participants feel that they are
better off because of the trade.

Both participants of an exchange of


goods and services anticipate an
improvement in their economic welfare.

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Economic Growth and Trade

The motive behind trade remains an


expectation of some enhancement
in utility or satisfaction by both
parties.

David Ricardo is usually given most


of the credit for developing the
economic theory that more
precisely explains how trade can be
mutually beneficial to both parties,
raising output and income levels in
the entire trading area.

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The Principle of Comparative


Advantage
The classical economist David
Ricardo's theory centers on the
concept of comparative
advantage.

A person, a region, or a country can


gain from trade if it produces a good
or service at a lower opportunity
cost than others.

An area should specialize in


producing and selling those items in
which it has a comparative
advantage.

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What is important for mutually


beneficial specialization and trade is
comparative advantage, not
absolute advantage.

For a highly productive nation to


produce goods in which it is only
marginally more productive than
other nations, the nation must take
resources from the production of
other goods in which its productive
abilities are markedly superior.

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Comparative Advantage, Specialization,


and the Production Possibilities Curve

The gains from comparative advantage


specialization in what one is a lower opportunity
cost producer ofcan be illustrated with a
production possibility curve.

By specializing in products in which they have a


comparative advantage, individuals, regions,
and countries can increase their total production
and it is trade that allows people to specialize
in those activities they do best.

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Wendys Production Possibilities Curve


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OCCLOTH = loss in food/gain in cloth


=10/5= 2 pounds of food/1yard of
cloth

OCFOOD = loss in cloth/gain in food


=5/10=1yard in cloth/2pounds of food

or

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1yard of cloth costs 2 pounds of food

1 pound of food costs yard of cloth

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Wendy can produce either food or


cloth along her production
possibilities curve. For Wendy, the
opportunity cost of producing a yard
of cloth is 2 pounds of food; and the
opportunity cost of producing a
pound of food is yard of cloth.

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Calvins Production Possibilities Curve


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OCCLOTH = loss in food/gain in cloth


=3/4= 3 pounds of food/4 yard of
cloth

OCFOOD = loss in cloth/gain in food


=4/3=4yard in cloth/3 pounds of
food

or
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1yard of cloth costs pounds of


food

1 pound of 1 pound of food costs


4/3 yard of cloth

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Calvin can produce either food or


cloth along his production
possibilities curve. For Calvin, the
opportunity cost of producing a yard
of cloth is pound of food; and the
opportunity cost of producing a
pound of food is 4/3 yards of cloth.

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Absolute and Comparative


Advantage

Lets compare Wendys production


possibilities curve to Calvins
production possibilities curve to see
who has an absolute advantage in
producing cloth and who has an
absolute advantage in producing food.

An absolute advantage occurs when


one producer can do a task using
fewer inputs than the other producer.

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Absolute and Comparative Advantage


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In this case, Wendy has an absolute


advantage producing food and cloth.

It is easy to see the absolute advantage,


because if she devotes all her resources to
producing cloth she can produce 10 yards
per day, while Calvin could only produce 5
yards.

In addition, if she devotes all her resources


to producing food she could produce 5
pounds of food and Calvin could only
produce 4 pounds of food.

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So who has the comparative advantage


(lowest opportunity cost) in producing food
and cloth?

Wendys opportunity cost of producing a


pound of food is 1/2 yard of cloth, whereas
Calvins opportunity cost of producing one
pound of food is 4/3 yards of cloth.

Therefore, Wendy is the more efficient


producer of foodshe gives up less in cloth
when she produces food, compared to Calvin.

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Who has the comparative


advantage in producing cloth?

That would be Calvin, because he


gives up only pound of food to
produce one yard of cloth. If Wendy
were to produce a yard of cloth, she
would have to give up two pounds
of food.

Therefore, Calvin is the more


efficient producer of cloth.

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Gains from Specialization


and Exchange

Suppose Wendy and Calvin meet and


decide to specialize in those activities in
which they have a comparative
advantage.

Wendy would specialize in the production


of food and Calvin would specialize in the
production of cloth.

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Gains from Specialization


and Exchange
By specializing, Wendy can produce
10 pounds of food per day (point B'
in Exhibit 4) and Calvin can produce
4 yards of cloth per day (point B in
Exhibit 4).

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However, to achieve any of the


gains from comparative advantage
and specialization, there must be
trade.

When they trade 3 pounds of cloth


for 3 pounds of food, each can enjoy
a combination of food and cloth
they could not have produced on
their own.

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The Gains from Specialization and Trade


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Individuals and Nations Gain from


Specialization and Trade

Just as Calvin and Wendy benefit from


specialization and trade, so do the people
of different nations. Because of
specialization, according to comparative
advantage, both nations can be better
off, even if one nation has an absolute
advantage in both goods over the other.

Furthermore, the greater the difference in


opportunity cost between the two trading
partners, the greater the benefits from
specialization and exchange.

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Regional Comparative Advantage

Trade has evolved in large part


because different geographic areas
have different resources and
therefore different production
possibilities.

In Exhibit 5, we see that Grainsville


and Techland have various potential
combinations of grain and
computers they can produce.
For each region, the cost of producing more
grain is the output of computers that must be
forgone, and vide versa.

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Production Possibilities,
Techland and
Grainsville

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Suppose that, before specialization,


Techland chooses to produce 75
computers and 10 bushels of grain
per day.

Similarly, suppose Grainsville


decides to produce 12 computers
and 18 bushels of grain.

Collectively, then, the two areas are


producing 87 computers (75 + 12)
and 28 bushels of grain (10 + 18)
per day before specialization.

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Suppose the two nations specialize.


Deciding to specialize in computers, Techland
increases the output to 100 units per day, some
sold to Grainsville.
Grainsville, in turn produces 30 bushels of grain
per day and sells some of it to Techland.

Both areas could, as a result, have


more of both products than before
they began specializing and trading.

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How can this happen?


In Techland, the opportunity cost of producing
grain is high25 computers must be forgone to
get 10 more bushels of grain.
In Grainsville, by contrast, the opportunity cost
of producing six more units of grain is six units
of computers that must be forgone; so the cost
of one unit of grain is one unit of computers.

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Computers are more costly (in


terms of opportunity cost) in
Grainsville and cheaper in Techland,
so Techland should specialize in the
production of computers.

We can see from this example that


specialization increases both the
division of labor and the
interdependence among groups of
people.

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20.3 Supply and Demand in

International Trade

Consumer surplus

Difference between the most a consumer


would be willing and able to pay for a
quantity of a good and what a consumer
actually has to pay

Producer surplus

Difference between the least a supplier is


willing and able to supply a quantity of a
good or service for and the revenues a
supplier actually receives for selling it

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The Importance of Trade: Producer


and Consumer Surplus

With the tools of consumer and


producer surplus, we can better
analyze the impact of trade.

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The demand curve represents a


collection of maximum prices that
consumers are willing and able to
pay for different quantities of a
good or service

The supply curve represents a


collection of minimum prices that
suppliers require to be willing to
supply different quantities of that
good or service.

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Trading at the market equilibrium


price generates both consumer
surplus and producer surplus.

Once the equilibrium output is


reached at the equilibrium price, all
of the mutually beneficial
opportunities from trade between
suppliers and demanders will have
taken place.

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The sum of consumer surplus and


producer surplus is maximized.

The total gains to the economy from


trade is the sum of consumer and
producer surplus.

That is, consumers benefit from


additional amounts of consumer
surplus and producers benefit from
additional amounts of producer
surplus.

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Consumer and Product Surplus


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Free Trade and Exports Domestic


Producers Gain More than
Domestic Consumers Lose

When the domestic economy has a


comparative advantage in a good
because it can produce it at a lower
relative price than the rest of the
world, international trade raises the
domestic market price to the world
price, benefiting domestic
producers but harming domestic
consumers.

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Free Trade and Exports

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Part of the domestic producers gain


comes at domestic consumers
expense.

While this redistributes income from


consumers to producers, there are
net benefits from allowing free trade
because producer surplus increases
more than consumer surplus
decreases.

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While domestic consumers lose


from the free trade, those negative
effects are more than offset by the
positive gains captured by
producers.

In net, export trade increases


domestic wealth.

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Free Trade And ImportsDomestic


Consumers Gain More than
Domestic Producers Lose

When a country does not produce a good


relatively as well as other countries, international
domestic price to the world price, with the
difference between what is domestically supplied
and what is domestically demanded supplied by
imports.

Domestic consumers benefit from paying a lower


price for the good, increasing their consumer
surplus.

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Free Trade and Imports

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But domestic producers lose


because they are now selling at the
lower world price.

While this redistributes income from


producers to consumers, there is a
net increase in domestic wealth
from free trade and imports
because the consumer surplus
increases more than producer
surplus decreases the welfare
gain.

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20.4 Tariffs, Import Quotas, and

Subsidies

Tariff

A tax on imported goods. They are


usually relatively small revenue
producers that retard the expansion
of trade.

Tariffs bring about higher prices and


revenues to domestic producers and
lower sales and revenues to foreign
producers.

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Tariffs lead to higher prices to


domestic consumers.

The gains to producers are more


than offset by the losses to
consumers.

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FEDERAL RESERVE BANK OF DALLAS

Buy American. The Job You Save


May Be Your Own. A common
myth is that its better for
Americans to spend their money
at home than abroad. The best
way to expose the fallacy in this
argument is to take it to its
logical extreme. If its better for
me to spend my money here than
abroad, then its even better to
buy in Texas than in New York,
better yet to buy in Dallas than in
Houston . . . in my own
neighborhood . . . within my own
family . . . to consume only what
I can produce. Alone and poor.

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55

The Domestic Economic


Impact of Tariffs

With import tariffs, the domestic price


of goods is greater than the world
price.

At the new price, the domestic


quantity supplied is lower and the
quantity demanded domestically.

Imports make up the difference.

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With tariffs being introduced, a


higher domestic price results in
domestic producers are willing to
supply more than domestic
consumers are willing to buy.

At the new equilibrium, the


domestic price is higher and the
quantity of goods is lower.

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At the new price, the domestic


quantity demanded is lower and the
quantity supplied domestically is
higher, reducing the quantity of
imported goods.

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Overall, then, tariffs lead to:


A smaller total quantity sold.
A higher price for goods for domestic
consumers.
Greater sales of goods at higher prices for
domestic producers.
Lower sales of foreign goods.

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While domestic producers do gain


more sales and producer surplus at
the expense of foreign producers,
and the government gains from
tariff revenue, consumers lose more
in consumer surplus than producers
and the government gain from the
tariff.

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Free Trade and


Tariffs

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Arguments For Tariffs

One argument for tariffs is that tariff


protection is necessary temporarily
to allow a new industry to more
quickly reach a scale of operation at
which economies of scale and
production efficiencies can be
realized.

This argument has many problems.

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How do you identify "infant


industries" that genuinely have
potential economies of scale and
will become quickly efficient with
protection?

Would it not be wise to make


massive loans to the industry in
such a case, allowing it to instantly
begin large-scale production rather
than slowly and at the expense of
consumers with a protective tariff?

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The history of infant industry tariffs


suggests that the tariffs often linger
long after the industry is mature
and no longer in need of
protection.

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Tariffs can lead to increased output


and employment and reduced
unemployment in domestic
industries where tariffs were
imposed.

Yet the overall employment effects


of a tariff imposition are not likely to
be positive.

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Not only might the imposition of a


tariff lead to retaliatory tariffs by
other countries, but domestic
employment would likely suffer
outside the industry gaining the
tariff protection.

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If new tariffs lead to restrictions on


imports, fewer dollars will be
flowing overseas in payment for
imports, which means that
foreigners will have fewer dollars
available to buy our exports.

Other things equal, this will tend to


reduce our exports, thus creating
unemployment in the export
industries.

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Sometimes it is argued that tariffs


are a means of preventing a nation
from becoming too dependent on
foreign suppliers of goods vital to
national security, but the national
security argument is usually not
valid.

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If a nation's own resources are


depletable, tariffimposed reliance
on domestic supplies will hasten
depletion of domestic reserves.

From a defense standpoint, it makes


more sense to use foreign supplies
in peacetime and perhaps stockpile
insurance supplies so that large
domestic supplies would be
available during wars.

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Dumping occurs when a foreign


country sells its products at a price
below their costs or below the
prices they are sold on the domestic
market.

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Some have argued that tariffs are


needed to protect domestic
producers against low-cost dumpers
because they will raise the cost to
foreign producers and offset their
cost advantage.

In practice it is very difficult to


prove dumping, foreign countries
may just have lower production
costs.

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Import Quotas

An import quota gives producers


from another country a maximum
number of units of the good in
question that can be imported
within any given time span.

The case for quotas is probably


even weaker than the case for
tariffs.

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Unlike what occurs with a tariff, the


U.S. government does not collect
any revenue as a result of the
import quota.

Despite the higher prices, the loss in


consumer surplus, and the loss in
government revenue, quotas come
about because people often view
them as being less protectionist
than tariffs.

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Besides using tariffs and quotas,


nations have devised still other,
more subtle means of restricting
international trade.

For example, nations sometimes


impose product standards,
ostensibly to protect consumers
against inferior merchandise.

Effectively, however, those


standards may be simply a means
of restricting foreign competition.

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Even if these standards are not


intended to restrict foreign
competition, the regulations may
nonetheless have that impact,
restricting consumer choice in the
process.

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The Domestic Economic


Impact Of An Import Quota

The introduction of an import quota


increases the price from the world
price, causing the price to rise
above the world price.

The domestic quantity demanded


falls and the domestic quantity
supplied rises.

Consequently, the number of


imports is much smaller than it
would be without the import quota.

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Compared with free trade, domestic


producers are better off but
domestic consumers are worse off.

Specifically, the import quota


results in a gain in producer surplus
and a loss in consumer surplus.

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However, unlike the tariff case,


where the government gains area e
in revenues, the government does
not gain any revenues with a quota.

Thus the deadweight loss is even


greater with quotas than with
tariffs.

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Free Trade and Import Quotas

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If tariffs and import quotas hurt


importing countries, why do they
exist?

They exist because of producers


lobbying efforts to gain profits from
government protection, called rent
seeking.

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Because these resources could have


produced something instead of
being spent on lobbying efforts, the
measured deadweight loss from
tariffs and quotas will likely
understate the true deadweight loss
to society.

2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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The Economic Impact of Subsidies

Working in the opposite direction,


governments sometimes try to
encourage exports by subsidizing
producers.

With a subsidy, revenue is given to


producers for each exported unit of
output, stimulating exports.

While not a barrier to trade like tariffs


and quotas, subsidies can also distort
trade patterns, leading to ones that
are inefficient.

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With subsidies, producers export goods


not because their costs are lower than
that of a foreign competitor, but
because their costs have been artificially
reduced by government action,
transferring income from taxpayers to
the exporter.

The actual costs of production are not


reduced by the subsidysociety has the
same opportunity costs as before.

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A nation's taxpayers end up


subsidizing the output of producers
who, relative to producers in other
countries, are inefficient.

The nation, then, exports products


in which it does not have a
comparative advantage.

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Gains from trade in terms of world


output are eliminated or reduced by
such subsidies.

Thus, subsidies, usually defended as


a means of increasing exports and
improving a nations international
financial position; are usually of
dubious worth to the world
economy and even to the economy
doing the subsidizing.

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CHRIS MADDALONI/ROLL CALL/NEWSCOM

In a comprehensive study, Professor Matthew Slaughter of


Dartmouth found that when U.S. firms hired lower-cost labor at
foreign subsidiaries overseas, their parent companies hired even
more people in the United States to support expanded operations.
For every job outsourced to India and other foreign countries,
nearly two new jobs were generated here in the United States. And
the new U.S. jobs were higher-skilledfilled by scientists, engineers,
marketing professionals, and others hired to meet the new demand.
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